Canada’s established stock markets and the upstart alternative trading systems are girding for a battle before regulators over “trade-through” protection, a fundamental market principle that both sides see as critical to the future of equity trading. The clash will effectively pit the imperative of investor protection against the virtues of increased competition.

The basic issue is whether traders should be required to take the best available price for a security or be free to execute trades at inferior prices. Traders may be eager to trade through and take inferior prices for a variety of reasons, such as execution certainty, speed or preserving anonymity.

The trading establishment argues that protection against trading through is essential to maintain market integrity, and particularly to protect the interests of small retail investors. Most rival ATSes, in contrast, maintain that imposing such an obligation indiscriminately would effectively hobble competition and stifle innovation in the trading business.

On Oct. 14, the two sides will battle it out at a public forum hosted by the Ontario Securities Commission. Ahead of the clash, the two sides have provided a preview of their arguments in submissions for a concept paper that was released earlier this year by regulators. The comment period closes Oct. 20, but any group that is interested in appearing at the forum is required to file its initial comments by late September.

Although they differ in some details, the established exchanges — the Toronto Stock Exchange, TSX Venture Exchange and regulator Market Regulation Services Inc. — support strong protection against trade-throughs. They argue that it is essential for market integrity and liquidity for small investors to know that their orders are protected.
If trade-throughs are allowed, they argue, investors will stop entering “limit orders,” pricing will degrade and liquidity will evaporate.

On the other side, ATSes such as Market Securities Inc. and Shorcan ATS Ltd. , along
with big institutional investors, including the CPP Investment Board, take the position that regulators should be cautious in imposing protection against trade-throughs and be mindful of the possible negative effects of competition between trading systems.

The battle lines recall an earlier public forum held by the OSC, when it first contemplated rules to integrate ATSes into the trading landscape. The meeting, held in the spring of 1998, was similarly divided, with strong opinions on both sides. The regulators eventually implemented their ATS rules in December 2001.

Since then, progress toward real trading competition has been fitful, and this latest dust-up over trade-through protection comes partly in response to the emergence of genuine competition — particularly MSI’s BlockBook trading system, which boasts that it is the first ATS to trade the same securities as the TSX. In its submission, MSI notes the system began live trading on Aug. 22, with 19 members: 15 institutional investors and four dealers.

The new system has raised the hackles of the trading establishment because the existing obligations regarding trade-throughs do not apply to it. Earlier this year, RS proposed a rule change that would extend such rules to cover market players such as BlockBook. However, the regulators denied RS’s request to impose that obligation immediately, preferring instead to launch their own consultation on the issue to try to determine whether trade-throughs do indeed hurt investors, how the harm arises and what can be done to prevent it.

At the time, RS CEO Tom Atkinson argued that it was wrong that any investor should have to suffer his or her order being traded through. The Canadian Securities Administrators, however, maintained it needed to see whether or not actual harm materialized.

So far, there is only limited experience with BlockBook in the market. In MSI’s comments on the concept paper, it says it has executed 14 trades so far (at an average order size of 93,665 shares and an average execution size of 47,357 shares). Nine of the trades occurred within the TSX quote and five were outside the quote, although it says three of the latter five came from the same order.

“Interestingly, in each of these cases, the TSX book reacted quickly to the BlockBook execution information and the better-priced orders were filled, even when there was no regulatory obligation to do so,” it reports. Each of the trades was very large, far in excess of 20% of average daily volume in the security, and this would typically have a substantial impact on prices, MSI adds. The firm notes that the data is preliminary, and it intends to present an updated summary of order and execution history at the public forum.

@page_break@The key question is whether such trades represent a real threat to investors and the integrity of the market and, if so, what kind of regulatory action is justified to prevent it.
It is much more than a philosophical exercise, because whatever solution is found will have a huge impact on the market landscape.

To see just how huge it can be, look to the U.S., where the issue was hotly debated at the Securities and Exchange Commission earlier this year. The commission ultimately voted to extend protection against trade-throughs to Nasdaq, which traditionally operated without it. The impact of this decision was soon felt in the exchange business.
The New York Stock Exchange proposed to buy electronic trader Archipelago Holdings LLC to increase its electronic execution capability; Nasdaq, in turn, snapped up Instinet to add scale to its already robust electronic market.

Incidentally, the issue was settled by a contentious split decision, with now-departed SEC chairman Bill Donaldson breaking a tie by siding with the two Democrats on the commission and against the Republicans. Donaldson was a Republican appointee, but he has subsequently been replaced by Christopher Cox, who is believed to be more friendly to business, so it remains to be seen whether the decision will ultimately be overturned.

In Canada, the issue may prove no less fundamental to the future of equity trading. In its submission, MSI argues that a regime hindering trade-throughs would severely affect competition in the stock-trading business.

“If one believes that any trade-through, no matter how small or how brief, presents an irreparable assault on the integrity of the capital markets as a whole, there is ample justification for the most onerous regimes of trade-through reduction,” MSI says. “The logical conclusion of this position is the support for one central limit order book. The resulting implication for competition among marketplaces is obvious: there will be no effective competition; the lowest common denominator will be served; and existing markets will be entrenched without incentive to change or innovate.”

In its submission, the TSX maintains that it has been innovative in response to pressure from global competitors, such as the NYSE and Nasdaq. “Because our global competition is larger than us, we are driven to be innovative and efficient in order to stay competitive,” the TSX argues.

The exchange suggests that the increased consolidation in the U.S. (NYSE-ArcaEx and Nasdaq-Instinet mergers) will make competition even tougher. “It is this competition, not the synthetic competition derived from regulatory arbitrage, that will allow our markets to grow and to meet the needs of our customers,” the TSX maintains.

Although the TSX may face competition from U.S. behemoths for the 200 or so securities that are interlisted (a relatively small number, which still represents about 60% of the TSX’s value traded), it so far has not seen much competition for the trading business in the rest of its listings. It probably won’t face serious domestic competition if, as MSI suggests, rivals face a substantial barrier to entry under a regulatory regime that requires compliance with blanket protection against trade-throughs.

The TSX notes that there is no smart order-routing technology available in Canada to direct orders among markets and avoid trade-throughs. Technology companies obviously are not going to invest in its development without multiple markets that need such integration. Yet new markets cannot easily get off the ground if they are required to start by ensuring integration with a competitor.

“If MSI had been required to resolve all of these issues as a prerequisite for market operation, I am very confident in stating that we would not have been able to persuade our shareholders to take this unbounded business risk,” MSI CEO Judith Robertson says in MSI’s submission. “For a start-up with limited capital, the risk [including that of delay caused by dependence on the co-operation of a competitor] would have been too great to overcome.” Once operational, that integration tends to occur naturally, the MSI comment notes.

But before a rival market can get to that point, MSI says, “The more different and innovative the new marketplace, the more difficult it is to establish the required integration to prevent trade-throughs.”

MSI is not the only new market starting up. Shorcan and TriAct Canada Marketplace LP are firms that are also seeking ATS status. Shorcan is a subsidiary of the inter-dealer bond broker Shorcan Brokers Ltd. It plans to offer an inter-dealer market for companies to carry out anonymous principal trading in equities. And TriAct is setting up a service that would match orders at the midpoint of the TSX spread.

And the ATSes do not all speak with one voice. TriAct, for example, notes that it is in favour of protection against trade-throughs “because we believe that such a requirement reinforces the fundamental principles of fairness and efficiency in the Canadian equity markets.”

In a swipe at its rivals, it adds, “We should not create competition by lowering the
standards of market integrity. Specifically, we do not believe that the rules should be changed to improve the competitive position of trading services that cater to large players who may benefit from bypassing the public market in certain situations.
Competition should improve trading services for customers, not create problems for customers or introduce practices that lead investors to question the basic fairness of the market.”

MSI, in turn, takes a shot at TriAct in its comment, saying that markets that seek to match limit orders before they get to the market “make no contribution to price discovery” and are “a true free rider on the price formation process of another marketplace.”

The jousting is not limited to rival start-up markets. In its comment, Shorcan takes RS to task for the latter’s efforts to extend the trade-through rule, calling RS’s campaign to do so “inappropriate and unwarranted.” Shorcan suggests the securities commissions review RS’s role as a rulemaker and a neutral enforcer, noting, “There is a definite lack of experience with marketplaces whose business plans and mode of operation differ from those of a stock exchange.”

RS argues that investor protection must come first. It says that market regulation should “above all other goals, protect investors from the effects of market failures. The other benefits of allowing market forces to operate, such as promoting innovation and competition, should be pursued only to the extent that they are compatible with investor protection, particularly the protection of retail investors’ interests.” RS emphasizes that regulation should not unnecessarily inhibit competition, but that investor protection must always be paramount.

RS notes that it is currently conducting research into the impact of disallowing trade-throughs on competition and innovation. Doug Harris, RS’s director of policy, research and strategy, says the research will be completed in time for its final submission on this issue on Oct. 20, but he is not sure whether it will feature in RS’s presentation to the public forum.

It remains to be seen how the regulators will come down on protection against trade-throughs. Given the importance of the issue and the stridency of the preliminary comments, however, it seems certain that the public forum will be a feisty one. IE