Rules of the Road : New Regulations for Canada
By Thomas Kalafatis
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.
Will the requirement to have ‘direct and exclusive’ control over DEA systems be perceived as a barrier to service for buyside clients? Will brokers have to adjust their DEA offerings for institutional investors?
The proposed DEA rules very clearly apply to all electronically generated flow. The Companion Policy states that “NI 23-103 requires automatic risk management filters for all orders entered electronically, including DEA orders” This means that, for self-directed buy-side clients entering orders through a DEA or DMA channel, risk filters under the direct and exclusive control of the broker will be required. The barrier to service raised by these filters will depend largely on the technology investment made by the broker – how fast and effective are their risk filters? If filters are slow and the buy-side client is trading a latency-sensitive short-term, alpha-capture strategy, the barrier to service could be significant.
It is important to note that there are many ways that the buy-side automatically generates orders – it might be through an OMS, or algorithms, or smart order routers. All of these flows will need to pass through automated filters controlled by the executing broker under the new rules. The DEA rules will disadvantage selfdirected buy-side clients relative to broker proprietary desks that will not require a duplicative set of risk checks. Consequently, a broker that has made the requisite technology investments will be increasingly beneficial to buy-side clients. We believe that the DEA rules will drive increased specialization by brokers, as the capital investment required to support DEA and SDMA services rises and makes the benefits of scale more relevant.
How will the proposed regulations affect latency sensitive traders, i.e. will pretrade risk monitoring add noticeable latency to DEA trades?
This is a difficult question to answer; ‘noticeable’ differs based on the DEA client’s priorities and trading strategy, and the level of filter technology provided by the broker. That being said, the most advanced hardware based pretrade risk systems claim latencies so low that on average, they blend with network and CPU cycle jitter – baseline random variability in latency – so that the risk filtering process does not affect the outcome of ultra-fast strategies. The use of these or other risk filter solutions depend on the client’s willingness to integrate third party tools into their automated system, and their broker’s willingness to invest in the infrastructure.
Any final thoughts on the proposed rules?
Electronic trading provides valuable and systemically important liquidity to Canadian equities markets. Accordingly, CIBC World Markets welcomes and supports a regulatory framework that facilitates electronic trading within acceptable risk limits and supervisory oversight. Canada arguably has the best developed market structure in the world, based on transparency, automated real-time regulatory oversight and responsible provision of direct electronic access, and our regulators are focused on ensuring that our structural rules evolve in step with the market.