Canadian securities regulators are proposing to impose some limits on the use of so-called ‘dark orders’ in the equity markets.

In a new consultation paper on the issue of dark liquidity, jointly published Friday by the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada, the regulators set out their positions on some of the regulatory issues regarding the use of dark pools and dark orders in Canada.

CSA and IIROC are proposing that only orders that meet a minimum size threshold be exempt from the pre-trade transparency requirements. This would apply to both dark pools and dark orders, regardless of the method of trade matching (continuous auction, call or negotiation systems), and for order type (client, non-client or principal).

The regulators also recommend that ‘meaningful price improvement’ be required for dark orders that don’t meet the minimum size exemption; and that, generally, visible orders should be executed before dark orders at the same price on the same marketplace, except where two dark orders meeting the minimum size exemption can be executed at that price.

“Our intention is to maintain the ability to execute large orders while managing market impact costs, and for smaller orders to continue to interact in dark pools with liquidity that may not have otherwise been available, subject to the requirement for meaningful price improvement,” the joint paper says.

“The recommendations aim to strike an appropriate balance between promoting marketplace competition and maintaining the quality of our markets,” said Jean St-Gelais, chair of the CSA and president and CEO of Quebec’s Autorité des marchés financiers, in a releae. “We are proactively establishing a framework that fosters development of dark liquidity without negative consequences to market integrity.”

The paper does not set out a position on some of the issues that were raised in a joint CSA-IIROC paper published on the same issues last year, and discussed in a follow-up forum earlier this year. For example, it doesn’t deal with the practice of dark pools using “indications of interest” (IOIs) to attract order flow; fairness issues involving the use of smart order routers; or the subject of broker preferencing.

The CSA indicates that the use of IOIs and smart order routers will be addressed in a separate CSA project to update the requirements applicable to alternative trading systems and exchanges. The issue of broker preferencing will be addressed in a future regulatory initiative, too. The regulators note that there are sharply divided opinions on this, ranging from those that believe broker preferencing is inherently unfair to those that say it doesn’t hurt markets at all. Regulators have concluded that they don’t have sufficient data to decide the issue, so, they intend to publish a request for information “in order to better evaluate broker preferencing and its impact.”

Indeed, the regulators indicate that they have undertaken a review of many of the market structure issues that they believe “need to be addressed immediately”. These include issues relating to dark pools, electronic trading, and the regulation of marketplaces. “Once our review is completed, we will seek feedback from the industry by publishing a number of different regulatory proposals or changes over subsequent months,” the paper says.

In terms of their position on dark orders, the regulators say they recognize that their position will impact existing business models and lead to systems changes. “However, in examining the issues and the risks of the expansion of the use of dark orders, we are of the view that the need for providing some limits on their use is critical in maintaining the quality of the price discovery mechanism and addressing concerns regarding the impact of dark orders on the quality of the Canadian capital market,” the paper says.

“The proposed changes will promote transparency and price discovery and enhance fair and equal access to liquidity for all investors, while recognizing the role that dark pools play in facilitating the execution of large orders,” said IIROC CEO and president, Susan Wolburgh Jenah.

The paper is out for public comment period until January 10, 2011.

IE