CSA proposals create a flood of feedback

The regulators are proposing several measures to address these various, interrelated issues, including setting limits on the application of the order protection rule (OPR), capping trading fees, intervening to control market data costs and initiating a pilot program to examine the prospect of banning trading rebates.

The comment period ended in late September. Not surprising, these proposals have generated a flood of feedback from the investment industry. Market structure reform is always a contentious issue because the trading business is extremely competitive and it’s pretty close to a zero-sum game. So, any regulatory action is going to resonate throughout the industry, threatening to create its own set of winners and losers.

Although there’s a great deal of nuance within the feedback that the CSA has received, the reaction breaks down into two camps, with dealers in favour of most of the CSA proposals and the marketplaces opposing most of them.

The positive reaction from dealers is hardly surprising, as much of what the CSA proposes aims to address criticisms of the current market structure that the dealer community has been voicing for a couple of years now – namely, that the existing regulatory environment forces a great deal of costs upon them.

Conversely, the markets fear that proposals designed to relieve some of the cost pressure will rebound upon them, altering the economics of their businesses.

At the heart of the CSA’s proposals is the OPR, which was implemented in 2011 and imposes a requirement to prevent so-called “trade throughs.” The OPR aims to ensure that better priced orders are executed first and that orders with better prices aren’t “traded through.” The twin intents are to instil confidence within investors that their orders are being handled fairly in the market and to encourage price discovery.

The long-standing complaint from dealers is that complying with the OPR requires them to connect with all available marketplaces to ensure they’re interacting with the best-priced orders. This forces dealers to participate in trading venues that they might not otherwise see much value in, and effectively creates a captive audience for the marketplaces, which reduces competitive pressures on costs, such as market data fees.

In some instances, according to the dealers’s comments, dealers are forced to subsidize trading venues that are adding little in the way of innovation and exist simply to collect revenue from dealers. The comments suggest that the tangible costs of the current regime far outweigh the perceived benefits for investor confidence.

To address this basic concern, the CSA is proposing to introduce a threshold for order protection so that dealers wouldn’t necessarily have to connect to every trading venue – just to the ones that have a meaningful share of the trading activity. (The CSA proposes a 5% threshold in market share). This is supposed to preserve the underlying goals of order protection – bolstering investor confidence and supporting price discovery – while reducing the extent to which dealers are forced to subsidize trading venues. Based on 2013 volumes, the only markets that would meet the 5% threshold are TMX Group Ltd.‘s markets, including Alpha, and Chi-X. Most of the other alternative trading systems (ATSes) would be below the proposed threshold.

In general, dealers are in favour of this proposal to limit order protection to markets that have a meaningful market share. For example, the comment from the wealth-management trading desk of RBC Dominion Securities Inc. “strongly agrees” with the CSA’s proposed approach, noting: “The biggest advantage to having an OPR threshold is that dealers can opt away from markets that allow predatory liquidity providers until the behaviour is corrected or mitigated.”

Some comments say the CSA should go further and do away with order protection altogether – and go back to putting the onus on dealers to ensure that their clients receive “best execution.”

Conversely, critics of the proposal from the trading side suggest that imposing a threshold for order protection will add even greater complexity to the trading environment, harm competition and create an insurmountable barrier to entry for new trading venues.

For example, the comment from Omega Securities Inc., which operates the Omega ATS, says, “The creation of a two-tiered market structure with enormous barriers of entry would be a mistake [that will] reward monopolistic activity and leave the equity markets exclusively in the hands of the institutions that control order flow.”

Furthermore, that comment continues, smaller ATSes “will be forced into the never before seen category of fully lit, unprotected marketplace, burdened with the regulation of a protected marketplace with none of the benefits.”

But the CSA’s proposals go well beyond simply establishing a new environment of protected and unprotected marketplaces. Also proposed are measures that would introduce greater regulation of the costs that trading venues impose upon dealers by capping trading fees and more closely regulating data fees. Perhaps even more significant, the CSA also proposes a pilot program to examine the impact of banning trading rebates.

Comments from the critics of rebates and the so-called “maker/taker” pricing model, which pays traders for adding liquidity and charges them for taking it, argue that this practice creates needless intermediation because traders employ strategies that are designed primarily to collect rebates rather than engage in any genuine trading activity that is intended to efficiently allocate capital. This situation, in turn, distorts the markets, elevates trading costs and increases market fragility by encouraging high-frequency trading that is tough to supervise effectively.

Defenders of the rebate practice maintain that rebates encourage liquidity and reduce trading costs by narrowing spreads.

The CSA’s proposal to study a ban on trading rebates is divisive, generally with dealers in favour and marketplaces opposed.

Says the comment from Scotia Capital Inc.: “We believe that the proposed pilot study may actually have a more dramatic and immediate impact on our market than the proposed rule changes.” (This comment supports eliminating maker/taker fee models.)

Adds the comment from TD Securities Inc.: “If rebates are eliminated in Canada, we expect several order books will be decommissioned in response, which will reduce market fragmentation and intermediation [as well as] improve natural order interaction and execution quality.”

Despite the support within the dealer community for regulatory action to reduce or eliminate the impact of maker/taker fee models, there is some concern that experimenting with the idea may cause some harm, particularly if interlisted stocks are included in the pilot program.

The fear is that trading in these stocks will simply migrate to the U.S. if Canadian exchanges aren’t allowed to pay rebates. Thus, some comments recommend that the pilot program exclude interlisted stocks to avoid this risk, while other comments suggest that Canadian regulators co-ordinate with their U.S. counterparts to carry out a cross-border test – although, with U.S. regulators engaged in their market structure debates, that prospect is unlikely.

Although Canadian dealers are generally supportive of the underlying goal of the pilot program, marketplaces are not. TMX’s comment suggests that regulators explore alternatives to banning trading rebates, warning: “The proposed pilot could have significant negative implications for liquidity and marketplace competition that will have follow-on effects for the quality of the Canadian markets.”

Even testing the idea of outlawing rebates could be risky, the TMX comment continues, noting: “It will be difficult to repatriate any volume lost to the U.S. during the course of the pilot.”

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