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.