After a few years of contemplation, securities regulators are nearing a decision on the contentious issue of how to impose trade-through protection in the Canadian market. They are leaning toward a regime that would require markets to provide protection for certain orders, yet offer freedom on how to do it.

The Canadian Securities Administrators has been considering various market structure issues ever since new technology allowed the rise of alternative trading systems. The latest topics to capture its attention are “trade throughs” and “best execution.” The CSA published concept papers about each area in 2005, and held a public forum that fall.

A trade through occurs when a trader doesn’t take the best available price and executes an order at an inferior price for some reason, such as faster execution, more certainty or to preserve anonymity. Some argue that orders should be protected against such trade throughs to preserve the integrity of the market, particularly when it comes to the orders of small retail investors.

This issue wasn’t particularly controversial when there was effectively just one market in Canada, but it has become more contentious with the proliferation of ATSes offering a variety of specialized services.

In 2005, Market Regulation Services Inc. called on the CSA to extend trade-through protection to the new ATSes that were just being launched. The CSA declined, indicating that it preferred to wait and see whether trade throughs became a problem as the new trading venues came onstream.

In the interim, the CSA held consultations on the issue. Battle lines were drawn, with the trading establishment on one side, demanding strong trade-through protection; the upstart electronic markets were on the other side, cautioning that indiscriminate trade-through protection requirements would stifle innovation and competition in the trading business.

Now, the CSA and RS are putting their differences behind them, and publishing a joint notice that spells out how they intend to deal with both issues.

“The joint notice outlines how RS is working with the CSA to ensure that a common set of principles applies to all market participants in a manner that supports the competitive operation of equity marketplaces in Canada while protecting inves-tors and ensuring the integrity of our markets,” Tom Atkinson, RS’s president and CEO, says in a news release.

As yet, the CSA still hasn’t quite made a decision on the trade-through issue. The notice sets out the regulators’ current thinking on the question, but declares “the issue is not yet settled.” Given the divergent views that exist on the subject, the CSA has decided to publish a proposed approach before it takes the next step and proposes rules.

The notice states that the CSA’s consultations in 2005 didn’t produce any real consensus on how to deal with trade throughs, but that a majority of participants did agree that all visible better-priced orders should trade before inferior orders.

Such a conviction forms the basis of the CSA’s proposed approach. Essentially, it would require each marketplace to establish and enforce policies and procedures designed to prevent trade throughs for “protected orders.” The idea would include any limit order that is displayed and can be “immediately and automatically” executed, across all available marketplaces.

The notice says that putting the obligation on the marketplaces to come up with policies to prevent trade throughs will “allow the industry to determine how best to implement the necessary changes. The purpose would be to promote price discovery, competition and fairness.”

Additionally, the CSA says, placing the obligation to prevent trade throughs on markets will necessitate effective monitoring and enforcement. The CSA suggests that it would perform the function for exchanges, and RS would do it for ATSes.

Although the CSA proposal envisions that markets would be required to protect against trade throughs across all available markets, it adds that this doesn’t mean that the markets must establish linkages with one another: “We think that there are alternative ways a marketplace could choose to implement its policies and procedures obligation without requiring mandatory linkages.”

For example, markets could prevent orders from being entered at inferior prices, prevent them from executing at an inferior price or allow the entry of intermarket sweep orders, among other things.

The crux of the trade-through debate has always been the need to protect investors and market integrity, but to do so in a way that doesn’t turn regulation into a tool that suppresses competition. With that in mind, it appears that the CSA is treading rather lightly. Its proposal poses a series of questions to help it refine the details of its plan, and it indicates that the regulators will be carrying out a cost/benefit analysis as well.

@page_break@The other major component of the joint CSA/RS notice is the introduction of a proposed definition of best-execution obligations that goes beyond just price.

The new definition is intended to capture other factors that may influence the quality of an execution, such as speed, certainty and total transaction cost. It also clarifies that advisors have best-execution obligations, as well as dealers. To harmonize RS rules with the proposed CSA amendments, RS is also proposing amendments to its trading rules regarding best-execution obligations.

Additionally, the regulators are proposing to require that both markets and dealers disclose certain information that will help assess compliance with best-execution obligations. The notice says that the information required from marketplaces would help dealers and advisors evaluate best execution based on the quality of the market, and the marketplace would inform technology providers for order-routing purposes. The notice also says that the disclosures will help clients examine the best-execution practices of their intermediaries. The hypotheses are to be tested with a cost/benefit analysis. The Ontario Securities Commission will survey investment dealers, marketplaces and other market participants to determine the value of disclosing the information.

Finally, the CSA is proposing further amendments concerning access, designed to ensure that participants that are not dealers are subject to the same rules, whether they enter an order directly on an ATS or through direct market access.

The regulators’ response to evolving market structure issues may have been a long time coming, but the happy result of their extended contemplation appears to be a fairly flexible approach to complex issues. IE