In an effort to address long-standing complaints about the adequacy of short-selling rules in Canada, the Canadian Investment Regulatory Organization (CIRO) is proposing to reforms designed to guard against failed trades by introducing mandatory “close-out” requirements.
The proposals follow recommendations from Ontario’s Capital Markets Modernization Taskforce in its final report in 2021, and a subsequent consultation by CIRO predecessor, the Investment Industry Regulatory Organization of Canada (IIROC), and the Canadian Securities Administrators (CSA), which revealed some support within the industry for mandatory close-out requirements.
“CIRO and the CSA have heard concerns of persistent failures to settle and that the current voluntary buy-in procedures in Canada are too lax and could contribute to a negative perception of capital markets in Canada,” the self-regulatory organization said in a notice setting out its proposals.
As a result, the regulators have decided to explore adopting mandatory close-out requirements, “to better understand if this approach would be appropriate to strengthen our regulatory framework,” the notice said.
Specifically, it’s proposing rules changes that would require mandatory close-outs that are “triggered when there is a prolonged settlement failure at a clearing agency by an investment dealer.”
The proposals would require dealers to close short trades that fail to settle within a specific time frame by buying or borrowing shares. Dealers that don’t close their positions on time would then face pre-borrow requirements in that security.
“We believe that this approach could achieve the regulatory objective of reducing persistent failures to settle while minimizing negative impacts on the industry where possible,” the notice said.
That said, CIRO also acknowledged that the proposals will have a significant impact on investment dealers, including requiring them to make significant changes to their systems, policies and procedures.
Among other things, firms will need to be able to monitor and track fail-to-deliver positions, to enact close-out transactions, and to make clients or traders arrange to pre-borrow securities where required.
This could particularly affect trading in junior securities, which have higher settlement failure rates, it noted.
The new requirements could also represent a greater challenge for smaller dealers, in terms of the resources needed to implement the new requirements. They “may also face restrictions in accessing securities where pre-borrowing may be required under the [proposals],” CIRO said.
Given the potential significance of the changes, the SRO said that it is seeking feedback on implementation impacts, costs, timing and alternative approaches.
In an effort to minimize the potential impacts of the new requirements, CIRO is proposing to adopt rules that would align with the U.S. approach in this area — which, it said, has proven effective at reducing settlement failures since it was adopted in 2004.
According to the notice spelling out its proposals, the SRO surveyed close-out rules in various jurisdictions, and concluded that it would be best to align with the U.S. regime by applying the new requirements at the clearing agency level, rather than as a new conduct rule.
“We have heard that this would facilitate increased efficiencies and contribute to a level playing field among [investment dealers] that trade in both markets,” the regulator said.
Structuring the proposed requirement as a conduct rule would result in a different trigger for close-outs, and would deviate from the U.S. approach, CIRO noted. It would also be more complex and costly to implement, it said.
Alongside the mandatory close-out proposals, the SRO is also proposing to extend settlement expectations to dealers that aren’t defined as market participants under the trading rules.
“Extending this requirement to all [dealers] would help ensure there is no regulatory gap so that the pre-trade requirement for a reasonable expectation to settle applies consistently to sales executed by all [dealers],” it said.
CIRO is seeking feedback from the industry by April 10.