Migrating trades

Those changes are designed, in part, to stem the flow of trading volume south of the border. At the same time, Canadian regulators also are contemplating whether regulatory action is required to help defend our markets.

What’s not clear, at this point, is just how big the problem of migrating liquidity really is.

A white paper that TMX Group issued in late October reveals that “some Canadian dealers are considering – or have already begun – changing their order routing practices” to send order flow south of the border to be executed with U.S. wholesalers.

Although the TMX Group paper suggests that this trend “represents a serious risk to the quality and vibrancy of Canada’s capital markets as a whole, and may have irreversible consequences,” the degree of the problem isn’t quantified.

Worries over order flow

Nor have regulators offered numbers. Both the Ontario Securities Commission (OSC) and the Investment Industry Regulatory Organization of Canada (IIROC) are worried about the prospect of Canadian order flow migrating to the U.S., but they haven’t put hard numbers on how widespread the phenomenon is.

“We are in the process of analyzing the extent of the issue. Therefore, it’s inappropriate to provide any statistics at this time,” says Wendy Rudd, senior vice president, market regulation and policy, with IIROC.

Susan Greenglass, the OSC’s director of market regulation, indicates that the OSC “has reached out to a number of Canadian dealers for information in this area.” Although the OSC isn’t prepared to quantify the magnitude of the threat, Greenglass indicates that the regulator is worried about the practice becoming widespread enough to damage domestic markets.

“We are concerned about the potential consequences for the Canadian market,” Greenglass says, “if significant amounts of Canadian investor order flow is directed to the U.S., and are examining the issue.”

Although TMX Group’s recent move to overhaul its trading model has brought the issue to the forefront once again, the question of Canadian dealers taking advantage of more favourable economics in the U.S. market has been on regulators’ minds for the past couple of years.

Given the differing regulatory frameworks and the significance of regulation as a driver of business models, regulators are concerned that regulatory arbitrage is taking place. Any such arbitrage implies that investors may not be adequately protected.

Rudd points out that changes to IIROC’s trading rules were proposed in 2012. Those changes included an “anti-avoidance provision,” which would prevent Canadian firms from executing small client orders in foreign dark pools unless those orders were executed at a better price.

Key differences

One of the key differences between Canadian and U.S. trading rules is that Canadian rules impose minimum “price improvement” standards for trading that takes place in the dark. TMX Group cites this provision – along with Canadian rules requiring fair access and banning payment for order flow – in its white paper as reasons for the more favourable trading economics that exist in the U.S.

However, the investment industry universally opposed the anti-avoidance amendments at the time they were proposed. Ultimately, the proposals were not adopted. Now, however, regulators appear to be rethinking that decision or contemplating alternative means of defending the Canadian market.

“While the anti-avoidance proposal was not finalized, we continue to monitor IIROC [dealers’] order-routing practices,” Rudd says. “And IIROC is considering various policy responses to help to ensure that the Canadian markets remain competitive.”

One possible approach to ensure competitiveness involves rule changes designed to prevent excessive southbound order flow. But TMX Group’s new CEO, Lou Eccleston, suggests that harmonizing rules between Canada and the U.S., then letting the market sort out the consequences, is his preferred approach.

In Eccleston’s first meeting with reporters since taking over from Tom Kloet in early November, TMX’s new CEO suggested that what’s needed is a set of common rules on both sides of the border.

Harmonized rules?

That’s not an idea that appears to hold much appeal for Canadian regulators, though.

“Although a harmonized set of trading rules might offer some benefit, given that the Canadian and U.S. markets share a level of interconnectedness, it is likely not practical,” says Greenglass.

Indeed, given the relative sizes of the two markets, harmonizing trading rules would surely mean changing Canadian rules to conform with U.S. rules – not the other way around.

And it’s not as though U.S. regulators have devised the optimal market structure and are just waiting for the rest of the world to catch up. Indeed, market structure reform remains a top priority for U.S. regulators.

And Canadian regulators don’t have much appetite for some of the existing features of the U.S. market.

“The structure of our two markets, although similar in many ways, have some very significant differences,” notes Greenglass, pointing to the fact that payment for order-flow arrangements are allowed in the U.S., unlike in Canada.

Given that common rules don’t seem likely any time soon, it appears that Canadian regulators will be devising ways to preserve their vision for domestic market structure; and, ultimately, a strategy to defend the future of the Canadian market.

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