Rules of the Road : New Regulations for Canada
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.
