Modern technology may have turned the equities trading business into a system too complex for anyone to grasp fully, so regulators are looking to impose some standards and controls on the players in that game.

Episodes such as the so-called “flash crash” in May 2010 and Jersey City, N.J.-based Knight Capital Group Inc.‘s near-meltdown earlier this year have revealed the vulnerability of markets to software glitches, so-called “fat finger” trades and runaway algorithms. And as the speed of trading grows faster, the risk that mistakes and errors do significant damage also grows, increasing the perceived fragility of the system.

Although regulators may not be able to ensure failure-free markets, they can set some standards for accessing the markets that will, hopefully, curb the systemic risk.

Earlier this year, the Canadian Securities Administrators (CSA) finalized a set of rules designed to govern electronic trading. Those rules don’t take effect until March 1, 2013, but the CSA now is proposing to amend them to set some standards for direct electronic access (DEA) as well – allowing investors to trade directly under their broker’s identification number rather than having the broker execute orders for them. At the same time, the Investment Industry Regulatory Organization of Canada (IIROC) is proposing amendments to its trading rules.

The CSA first published rule proposals concerning DEA in April 2011 as part of the new rules to govern electronic trading in general. However, the CSA chose not to finalize the portion dealing with DEA along with the rest of the rules, in order that its proposals could be harmonized with IIROC’s proposed changes.

Taken together, the two sets of proposals (which are out for comment until Jan. 23, 2013) aim to create a regulatory framework for the provision of DEA in order to guard against a variety of risks that arise when firms or individuals who aren’t dealers have direct access to the market.

According to the CSA’s proposal: “Allowing the use of complicated technology and strategies, including high-frequency trading strategies, through [DEA] brings increased risks to the participant dealer.”

For example, the CSA proposal notes that a dealer could be held financially responsible for erroneous trades that are entered under its broker ID – even if it could bankrupt the firm. And dealers also could be held responsible for compliance violations by their direct-access clients.

The magnitude of those risks alone would seem to be incentive enough for dealer firms to ensure they are keeping a close eye on any trading that is done in their name. But the regulators see the need to set some minimum standards to ensure the dealers are taking responsibility for their direct-access clients, protect against systemic risks that could arise and eliminate possible opportunities for regulatory arbitrage.

IIROC’s proposal indicates that the regulator believes that there should be a common set of rules for DEA that applies across all marketplaces: “This common set of requirements would protect overall market integrity and facilitate trading in a multiple marketplace environment. [The proliferation of sophisticated, high-speed trading technology] has caused various risks to emerge, including financial, regulatory, legal and operational risks associated with electronic access to marketplaces.”

So, the CSA’s proposal would: set standards for direct-access clients; require written agreements between clients and dealers; mandate that firms ensure the proficiency of their DEA clients; and require that orders from DEA clients be marked so that regulators can easily identify them.

At the same time, IIROC’s proposed amendments would: introduce requirements for dealers, including provisions governing routing arrangements, imposing order supervision requirements and establishing gatekeeper obligations for both the markets and the dealers that provide DEA; and prevent retail clients from both using automated order systems and exceeding a limit on the number of orders these clients can send to the market.

In setting standards for DEA clients, the CSA proposal would establish that only investment dealers can provide DEA – and only portfolio managers at registered firms can use it. This means other sorts of dealers won’t be eligible for direct access through another firm’s trading ID.

The previous version of the rule had contemplated that other dealers would be able to be DEA clients, but specifically excluded exempt-market dealers (EMDs). Now, the CSA has decided to exclude all dealers from direct access, including EMDs. (Dealer-to-dealer order routing is now dealt with in IIROC’s rules.)

The original proposal to exclude EMDs from DEA attracted a lot of comments arguing that it’s unfair to disallow it for those firms when other sorts of firms, even those that aren’t registered, can secure market access that way.

The CSA is sticking to its guns. Its rationale for continuing to exclude EMDs is its concern about regulatory arbitrage. Last year, the CSA issued a notice indicating that it’s worried about some firms, particularly U.S.-based dealers, using EMD registrations to provide brokerage services to Canadian clients without complying with the same rules as IIROC dealers.

IIROC is proposing to deal with this end run by creating a new registration category for such firms and eventually moving them to full IIROC membership. IE

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