CIBC’s Thomas Kalafatis maps out the new CSA rules regarding direct electronic access and suggests its potential effects on brokers and institutional traders.
Are the updated Direct Electronic Access (DEA) requirements a response to patterns endemic to Canada or are they a response to patterns observed elsewhere? Given the existing Investment Industry Regulatory Organization of Canada (IIRO C) rules and the timing of the Canadian Securities Administrator (CSA)’s DEA rule proposal, it is fair to say that the rules proposed by our regulators are intended to maintain consistency with changes in other jurisdictions and prevent regulatory arbitrage. We do not believe that the rules are the result of a specific effort to solve a localized Canadian problem, but rather a preventative measure to ensure structural issues that have arisen elsewhere will not take root in Canada.
The issues around direct electronic access raised in the United States (who is accessing marketplaces directly, and how they are ensuring automated systems will not malfunction) are less of a concern in Canada. TMX rule 2-501 limits who is eligible to receive DEA access, restricting DEA to wellcapitalized firms, or firms that are registered and regulated in certain other jurisdictions.
IIRO C Notice 09-0081 addresses how automated systems should be managed to mitigate the risk of malfunctions. It requires brokers to manage the risk of electronic trading by clients in the same way that they manage the risk of their own electronic trading. This includes ensuring that automated risk filters are in place, that order flow from an automated system can be interrupted/switched off by the broker, and that strategies are tested prior to being deployed to market. These basic, principlesbased protections have been effective at mitigating risk in Canada since well before the wave of automation hit our markets in 2008.
The proposed DEA rules are a movement away from the IOSCO principles-based approach that has traditionally been taken in Canada, towards a more prescriptive regime more like the 15C-3-5 rules introduced by the SEC in the United States this year. This builds consistency between the Canadian and American jurisdictions that are so closely intertwined.
Automated pre-trade risk filters are in place for many brokerdealers. How difficult will this regulation be to implement? Broker-dealers will need to monitor the proposed rules closely, particularly with regard to their Sponsored Direct Market Access (SDMA) clients. These clients have their own sophisticated automated risk management systems in place – as required by UMIR rules and, more importantly, as a result of their own risk aversion. They connect directly to exchanges to minimize latency. The DEA rule proposes to change this, in parallel to 15C-3-5 in the US, in that brokers will need to have “direct and exclusive control” over the risk filters on client flow; this means that a duplicative set of filters operated by the broker will have to be put in place.
In this case, Canadian brokers benefit from the earlier adoption of 15C-3-5 in the United States where various technologies have been developed to meet SEC rules that went into effect in the summer of 2011. Depending on the needs of its client base, a Canadian broker can choose between several types of risk filter offerings operating in a latency range from the low milliseconds to the low microseconds. The only differentiator is cost, with a significant premium on the single-digit microsecond lowest latency offerings.
Generally, it is not economic for a Canadian broker to develop the ultra-low latency solutions in-house, and the Canadian broker community benefits from the availability of third party technologies developed to meet the US rules that came in to effect earlier this year.
It is a fact that the FIX Protocol generates significant cost savings for the Global Financial Services Community. This fact is further attested by the findings of a recent study, explains Daniella Baker, FPL Marketing and Communications Manager of FIX Protocol Limited.
The past 12 to 18 months sent shockwaves through the very core of our industry. As the world’s financial markets continue to grapple with the impact of the global economic crisis, achieving greater cost reductions and generating increased efficiencies are goals that are riding high on most corporate agendas. During this period the landscape has shifted, regulatory changes have been implemented and new trading practices have emerged. As we move swiftly towards the close of the first decade of this millennium, FPL is proud to release a study entitled ‘The Benefits of the FIX Protocol’, which was produced by Oxera, one of Europe’s leading independent economic consultancies.
Oxera worked closely with Barry Marshall, previous Co-Chair of the FPL EMEA Regional Committee and Jim Northey, Co-Chair of the FPL Americas Regional Committee and Co-Founder of the La Salle Technology Group to deliver the report. The study explores the benefits that flow from the use of FIX in capital markets and amongst other findings, identifies the significant cost savings, reduced operational risk and the longer-term value that greater use of the protocol could deliver in terms of generating increased market efficiencies.
The timing of this study comes at a very poignant point in the history of FIX, as we are witnessing winds of change in adoption. FIX was originally developed as a buyside to sell-side communications tool, however trading venues and regulators across the globe are starting to take note. Listening to their user communities, they too are expressing significant interest and in many cases implementing the protocol.
A prime example of this is the Investment Industry Regulatory Organization of Canada (IIROC) and their plans to offer a new FIX-based market regulation feed specification for market surveillance and transaction reporting.
As the FIX Protocol has developed, its functionality has been significantly enhanced to provide support across the trade lifecycle for multiple asset classes. To put the impact of FIX support into perspective, the study identified that the size of the markets that currently benefit from the protocol now include the USA, Europe and Asia- Pacific equity markets, which in 2008 had an annual turnover of $113 trillion, in addition to a significant number of emerging equity markets; the government and corporate debt securities markets, which had an outstanding value globally of $83.9 trillion in June 2009; the exchangetraded derivatives markets, with notional amounts in the USA, Europe and Asia-Pacific in June 2009 of $63.4 trillion and the global over-thecounter (OTC) derivatives markets, with notional amounts in December 2008 of $591 trillion.
Delivering Actual Benefits So why has FIX proved so popular, what are the real economic benefits it offers to adopters and how can it help to achieve increased market efficiencies?
The study identifies the answers to these questions as lying in the fact that FIX offers a standardised and industry-wide solution. Standards produce ‘network effects’ because as more parties adopt a particular way of doing something, there is greater immediate benefit for new parties that subsequently adopt the same way of doing it, as well as increasing the value to those who have already adopted it.
From a FIX perspective, these benefits translate into reduced connectivity costs as FIX reduces the time and complexity involved in connecting to multiple trading partners across different geographies. Once a firm has made an initial investment in implementing FIX they can then leverage this investment across additional partners. Also, by integrating internal processes and external operations and reducing manual error rates, FIX enables firms to benefit from increased efficiencies and reduced operational risk. These factors in turn can generate greater levels of competition and innovation as switching costs are reduced and suppliers now need to provide improved service levels and more economical alternatives to remain competitive. The diagram below demonstrates the benefits that can be achieved by network effects:
Prime examples of how these factors have delivered actual benefits is the increased number of alternative trading systems now active in the U.S. As commented in the ‘The Benefits of the FIX Protocol’ study this has been significantly facilitated by standardised connectivity solutions such as FIX, because FIX enabled brokers to connect to these new trading platforms for a comparatively small cost.
From a European perspective, when the Markets in Financial Instruments Directive (MiFID) was introduced, neither the directive itself nor the Committee of European Securities Regulators (CESR) addressed the issue of communications standards for electronic trading and market data publication. At this point, many EU based exchanges operated private communications environments with proprietary message formats, which presented significant connectivity costs for users.
However, just over two years after MiFID was introduced, we are now witnessing a similar pattern in Europe as seen in the US, with several new trading venues emerging, including Chi-X, Plus Markets, Turquoise, BATS Europe and NASDAQ OMX Europe, many of which offer FIX connectivity options and present competition to the incumbent exchanges.
BMO Capital Markets’ Andrew Karsgaard outlines the new regulations regarding dark liquidity in Canada and how firms can use them to their advantage.
Canadian market participants are bracing themselves for another year of significant change. While exchanges, themselves, consolidate, liquidity continues to fragment across venues. Regulatory proposals on dark liquidity are being considered. New entrants, both lit and dark, wait in the wings for the right moment to set up shop. In this constantly changing environment, the tools available to a trader to access and analyse liquidity across markets have become critical to their success.
Regulators Looking at Dark Liquidity
In November 2010, the Canadian Securities Administrators (CSA) and the Investment Industry Regulatory Organization of Canada (IIROC) issued a Position Paper containing proposals on the subject of dark pools and dark liquidity. The proposals are summarised here, but let us focus briefly on how the debate around dark liquidity is evolving in Canada.
The regulators’ proposals were prefaced by the statement that “in order to facilitate the price discovery process, orders entered on a marketplace should generally be transparent to the public...” This seemingly innocuous perhaps, unarguable assertion has, in fact, prompted considerable debate in the market structure blogosphere. Critics of the proposals argue that there is no evidence of damage to the price discovery process in markets where dark liquidity exists. They argue that transparency should not be an end in itself, as the true objective is best execution. Non-transparent ways of trading have existed forever, because they provide an important way to minimise market impact when executing large orders.
Many go further, arguing that the insistence on transparency is actually damaging, as it has created a network of continuous, linked auction markets that are susceptible to gaming, and therefore, represent toxic pools of liquidity. By placing restrictions on dark liquidity, regulators are potentially forcing investors to participate in these pools. Canadian regulators have a history of pro-actively analysing and responding to market structure changes. Their rules concerning multiple markets were ready before the first lit ATS began operations, and they are the only regulators in the world who are active, direct members of FIX Protocol Limited, contributing to the creation and maintenance of standards in electronic trading. Generally speaking, they are engaged and well-informed. In this case, by getting ahead of the game on dark liquidity, there is a danger of throwing the baby out with the bath water.
Our uniquely Canadian broker preferencing and on-exchange crossing systems, along with the TSX’s market-on-close facility, create hybrid forms of grey liquidity, where size is not exposed to the glare of the continuous market, but where price formation and discovery still occurs. Broker preferencing takes internalisation, which is completely dark, and displays it - every trade - on a public venue. This contributes to price formation to a much greater degree than the broker-run dark pools in the US, which are not obliged to publish trades unless they reach a certain size. Dark liquidity is not the problem in Canada. We currently have a single dark pool, but we have some interesting methods of merging lit and dark liquidity that could act as models in other countries. Is it possible that these proposals focus on the symptoms rather than the disease?
New Entrants Waiting in the Wings
Awaiting the outcome of the consultation period and the final CSA/IIROC view on dark orders, are a number of potential new entrants to the Canadian market, as well as a number of new facilities being offered by existing market operators. Alpha – a well-established ATS owned by a consortium of large dealers – submitted proposals to the regulators for their Intraspread order type (essentially a broker internalisation facility) in the second half of last year. Around the same time, TMX submitted an application for their own non-displayed order types, including a non-displayed midpoint order and a non-displayed Limit Order. MatchNow, currently Canada’s only electronic dark pool, proposed an addition to their existing dark pool, offering an “internalise only” order type.