Market regulation Services Inc. and the Canadian Securities Administrators are butting heads over the market regulator’s desire to extend trade-through obligations to institutional investors.

Rather than grant RS its wish, the CSA has decided to publish a concept paper on the issue, probably by late June or early July.
The paper will go out for a 90-day comment period, and the regulators hope to decide how the issues should be handled by winter, although it will surely take longer for a rule to take effect.

Trade-through protection forces market players to fill better-priced orders first, even though they may prefer to execute at a lower price for some reason, such as faster or more anonymous execution. The issue may be an obscure one to the average investor, but it’s exceedingly important, since it impacts overall market liquidity as well as the fairness and efficiency of equity trading.

The trade-through issue is coming to a head now for a few reasons. Alternative trading systems, which could allow trade-throughs, are clamouring to enter the Canadian market, and U.S. regulators recently decided in favour of broader trade-through protection after two years of debate.

In April, the issue was the subject of a highly contentious meeting of the U.S. Securities and Exchange Commission, where it decided, in a three-two vote, to extend trade-through obligations to the Nasdaq and other national markets.

The two dissenters argued that trade-through obligations are anti-competitive and should be scrapped altogether. The majority maintained that the protections are necessary to prevent retail investors from losing out as their orders are traded through. It’s a problem, they argued, that may not only disadvantage the individual investor on an individual trade, but may also harm market integrity overall.

The move was widely cited as one of the primary motivators for the subsequent flurry of deals between trading venues: the New York Stock Exchange’s surprise decision to buy the electronic trading platform Archipelago Holdings Inc. and seek a public listing; and, Nasdaq’s move to snap up Instinet, which will fundamentally reshape the trading landscape in the U.S.

In Canada, there’s competitive pressure afoot as well. Toronto-based Markets Inc. is launching an innovative institutional trading system, known as BlockBook, which seems to be the source of much of the angst surrounding the threat posed by trade-throughs.

Markets announced May 10 that it had received regulatory approval for BlockBook, a fully-automated electronic trading network that preserves order and investor anonymity while monitoring the market for trading opportunities. It aims to improve choice and liquidity, while lowering trading costs for large institutional investors. The venture is backed by a variety of concerns, including the Ontario Teachers Pension Plan Board, B.C. Investment Management Corp., CDP Capital, National Bank Financial, CI Mutual Funds Inc., Skylon Advisors Inc., Shorcan Brokers Ltd. and CIBC.

Apart from BlockBook, regulators confirm there are other ATSs exploring the possibility of bringing their services to Canada, although they refuse to name names.
Nevertheless, the prospect of ATSs shaking up the equity trading game is once again rearing its head in Canada. The possibility that the fundamental changes will have negative consequences for some investors, particularly smaller investors, has some people worried.

Tom Atkinson, president and CEO of RS, says that it finds itself caught on the horns of a dilemma. The securities commissions are refusing RS’ request to extend trade-through obligations on the basis that it can’t demonstrate that investors will be hurt, and it can’t prove that investors will be hurt by the lack of trade-through protection until investors actually are hurt.

The securities commissions take the position that it would be premature to broaden the application of existing trade-through rules without the evidence of actual harm. Randee Pavalow, director, Ontario Securities Commission’s capital markets division, says that while RS could conjecture that trade throughs will result in harm to investors, it couldn’t demonstrate the fact with any certainty.

RS maintains that the lack of trade-through protection will hurt investors in a few major ways. Investors who find their orders traded through will be disadvantaged on the specific trades, and market liquidity and integrity overall will suffer if a preponderance of trade throughs leads investors to stop posting limit orders, the sort of order that tends to be affected by trade-throughs. That said, it will only be able to prove this to regulators by actually observing harm suffered in the market.