It took years for alter-native trading systems to grab a toehold in the Canadian market. Many finally have sprung up, but now they’re worried that proposed regulatory changes could make the market less hospitable.

The main concern is regulatory fees. The ATSes are fretting that planned changes to the charges assessed by Market Regulation Services Inc. could mean much higher operating costs, which would hamper their ability to compete and create a barrier to entry for prospective new players. Moreover, they suggest, RS remains too cozy with the dominant player in the market — TSX Group Inc. , the firm from which RS was spun off.

The ATSes have been expressing concerns in comments submitted to reform proposals published by RS in the past few months.

Last November, RS issued initial plans for overhauling its fee structure. It proposes imposing various charges to cover the capital cost of new players joining the market. RS also indicated in mid-January that it would be proposing a new fee model to cover the cost of providing day-to-day oversight. It is also developing another proposal to finance the costs of consolidating markets’ regulatory data and developing displays and tools to provide effective cross-market monitoring.

The underlying rationale for altering the regulatory funding structure is the fact that the Canadian trading environment has changed in the past few years.

Several new trading systems have joined the market, and others are on the way. This has increased the demand for market regulation. For one, RS notes, the emergence of algorithmic trading has greatly increased the number of orders in the market. Orders are up 171%, whereas trading volume is up just 21%, in the four years since RS began overseeing the market.

Moreover, the new trading venues bring added regulatory costs — beyond the creation of greater trading volume — because RS must develop technology to allow automated monitoring of the trading activity. In the meantime, it must manually monitor such trading.

Therefore, RS wants to reform its fee models to reflect the changes, essentially by matching regulatory fees to the direct costs of providing oversight for a particular market. All these shifts probably mean higher regulatory costs for the ATSes.

In terms of the fees RS levies to integrate new trading venues, the regulator is proposing that the charge for administrative start-up costs would double to $50,000, although actual costs already average almost $46,000. New markets would also be required to cover their connection costs and any market-specific costs that arise when integrating them. As well, the new markets would share equally in the $300,000 cost of modifying RS’s systems to receive data from the markets it can’t monitor on an automated basis — currently, all but the TSX markets and Bloomberg Tradebook.

Similarly, the proposed new fee model would also see the ATSes’ regulatory costs rise. Currently, RS collects fees based on trading volume, regardless of where the trades take place. Under the proposed new fee model, RS would track the costs and charge fees based on the various functions it performs — surveillance, reviews, investigations, enforcement, etc. — for each market. The idea is to allocate costs more directly to the markets that generate them, and base their monthly fees on the allocation.

Under this proposal, it is estimated that the regulatory fees for the ATSes could increase four- to sevenfold, whereas the fees for the two TSX platforms would decrease. For example, according to RS’s calculations, under the current model, ATSes paid a $500 monthly trading fee for September 2006. Under the new model, they would have paid $2,000-$3,500 for the month. TSX Group’s trading fee costs would probably fall by a similar amount.

So far, none of the proposals are sitting very well with the ATSes.

In response to the initial proposals, four ATSes — Perimeter Financial Corp. ’s BlockBook, CNQ and Pure Trading (both operated by Canadian Trading and Quotation System Inc. ) and TriAct Canada Marketplace LP — jointly submitted a comment complaining that, among other things, the proposed changes are unfair. They say new markets would be required to fund all the development costs of a system for monitoring multiple markets, while TSX Group would not. They also have some serious governance and transparency concerns.

And they argue that RS’s relationship with TSX Group creates a conflict of interest. Specifically, they say, because TSX Group retained the market surveillance technology when RS was spun off and remains RS’s technology provider, a clear conflict exists when it comes to allocating the costs.

@page_break@They argue that RS should find an independent technology provider before it starts altering its fee methodology.

Doug Harris, RS’s director of policy research and strategy, says the firm will address the concerns around its use of TSX Group as its technology provider when it responds to the comments submitted to its various fee proposals. Submissions on the allocation of costs to new markets had to be in by Dec. 17, and comments on the proposed new fee model were due Feb. 12.

In the second round of comments, the ATSes have expressed similar concerns about the proposed new monthly fee model. Even if RS insists that it is necessary to change the current fee model, they argue, the proposed model is not the right way to go — for a number of reasons.

For one, it is complex. Moreover, they suggest, it could create situations in which a market’s regulatory fees are greater than its trading revenue in a given month. Charging disparate fees for trading the same securities based on the trading venue is unfair, they add, and could undermine traders’ efforts to ensure they are achieving “best execution” for their clients. The model is also not complete, pending publication of the proposal to provide effective cross-market monitoring.

“The fee proposal is seriously flawed, violates the principles of fairness, transparency and accountability, and should be withdrawn,” argues CNQ in its comment letter. “It replaces a relatively straightforward model with a highly complex and opaque one. There is no analysis or justification provided for a complete change in the way RS recovers its costs, which makes it impossible for the affected marketplaces to respond fully and to calculate the impact.”

The complaints are echoed by TriAct, which says in its comment: “While RS’s recognition order requires, among other things, equitable allocation of fees, neutrality among marketplaces and mitigating barriers to entry, we believe that this proposed fee model creates an uneven playing field that favours the incumbent TSX over new entrants. We would suggest that it would have the net effect of discouraging competition in Canada.”

Moreover, the ATSes question the wisdom of overhauling the RS fee model when it is in the midst of contemplating a merger with the Investment Dealers Association of Canada. CNQ stresses that no changes should be made to the fee model while TSX Group remains RS’s technology provider, the planned merger with the IDA is incomplete and until RS has more experience monitoring multiple markets.

While the ATSes admit that the current fee model is not perfect, they insist that it is not so flawed that it requires a dramatic overhaul.

One alternative, submitted by Global Financial Group Inc. , which is developing a global securities exchange system designed for the listing and trading of real estate securities, is basing fees on the number of trades rather than on trading volume. “We believe,” GFG’s submission says, “the number of trades may correlate more closely with the cost of regulation than trading volume, and is certainly easier to administer than the cost drivers set out” in the proposed fee model.

Harris indicates that RS is considering all of the various comments and waiting to hear what the securities commissions have to say on the proposals. IE