The View from Canada


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.
In response to this avalanche of new requests, regulators placed a halt on developments while they issued their proposals and considered responses. All of these operators are eagerly awaiting the outcome of that process and they are joined in their anticipation by the large domestic and international brokers. Many of these operate internalisation pools in other jurisdictions, and can be quick to market with a Canadian version, should circumstances and regulators allow. The existence of broker preferencing (see previous page and box below) has prevented the development of broker-run dark pools in Canada until now. Should regulators allow the existence of additional dark pools in Canada, some flow would likely migrate there. The immediate impact of which will be an increase in the need for Canadian dark pool aggregators. While many participants have deployed these for their US trading already, work would be required to configure them to consider Canadian dark pools.
In the lit market space, there is also a great deal of potential change. BATS and DirectEdge are logical entrants to the Canadian market. Indeed the merger of BATS and Chi-X, which already has a presence in Canada, may have brought that a step closer.
Tools to Navigate the New Landscape
No matter how many new dark pools or lit venues open up shop in Canada in 2011, traders will require more sophisticated tools to access and analyse liquidity.
Accessing liquidity is the job of the Smart Order Router (SOR). Canada is entering the 3rd generation of SORs. The first were essentially serial trade-through protectors. The second generation were slightly more sophisticated spray routers, with some better support for handling the passive or unfilled portion of an order. The third generation of SORs consume latency and execution quality data as part of the order routing process, dynamically shifting child order placement as the liquidity picture changes.
Analysis of liquidity will be an area of real growth in Canada in 2011. Execution quality reporting and analysis is essential to what should be a disciplined best execution regime within every market participant, and the ability to feed execution quality information back to Smart Order Routers in real-time is critical to the implementation of the third generation SORs mentioned above. The FIX Protocol supports valuable data in that regard – tag30, represents the market of the fill and tag851 indicates whether the fill was the result of making or taking liquidity, which are vital data in determining execution quality. This determination is as equally vital for the sell-side as for the buy-side trader as they choose execution service providers, be they brokers’ algos or actual venues and their various order types.
Market structure is in a state of flux in Canada, and any attempt to describe the current state of affairs risks being out of date as soon as it is published. What is certain, however, is that as Canada develops as an electronic marketplace, participants will have to arm themselves with the appropriate tools to access and assess liquidity. The ability to access equity markets, and to make the necessary changes when any new marketplaces or order types arise, is a minimum standard for market participants. Those who can analyse order routing data and make the results of that analysis relevant and meaningful to their clients will exceed that minimum standard and prosper, no matter what the Canadian equity landscape looks like.

Summary of CSA/IIROC Dark Order Proposals

  • An exemption to the pre-trade transparency requirements should only be available when an order meets or exceeds a minimum size.
  • Dark Orders should only be required to provide meaningful price improvement over the NBBO when executing with an active order which does not meet the minimum size exemption.
  • Visible orders should execute before Dark Orders at the same price, on the same marketplace, except where two Dark Orders meeting the minimum size exemption can be executed at that price.
  • Meaningful price improvement should be one trading increment as defined in IIROC’s Universal Market Integrity Rules (UMIR). However, for securities with a difference between the best bid price and best ask price of one trading increment, one-half increment will be considered to be meaningful price improvement.