Canadian regulators have peered across the border and don’t like what they see.
The countries Canada’s three main regulators–Canadian Securities Administrators, the Ontario Securities Regulator and the Investment Industry Regulatory Organization of Canada–are on the verge of jointly proposing new rules that could nip U.S.-style dark pool trading in the bud.
Behind the move is a long history of transparency in the Canadian marketplace and fears that the current trend towards electronic trading will usher in a significant dark market similar to that in the U.S. In Canada, nearly all orders are exposed on an exchange or other "lit" market before trading.
The regulators made plain their concerns in a recent "position paper" published in November.
"In examining the issues and the risks of the expansion of the use of dark orders, we are of the view that the need for providing some limits on their use is critical in maintaining the quality of the price-discovery mechanism and addressing concerns regarding the impact of dark orders on the quality of the Canadian capital market," the regulators wrote.
Of greatest concern to fans of dark pools is the imposition of a minimum-trade-size clause. This would bar the posting of any "passive order" in a dark pool if it fell below a certain size threshold and require the dark pool operator to price improve any "active" order that fell below the threshold. The result would be to force brokers to route more orders away into the lit markets.
Market sources said 5,000 shares is the expected minimum size allotment, but nothing has been announced publicly by Canadian regulators. Currently, small orders may be crossed inside a brokerage house but must be taken to the public markets for the print.
The ruling in question is actually a clarification of Rule NI 21-101 sections 7.1 (1) and (2), which requires pre-trade order transparency. The regulators appear to be leaning towards exempting dark pools from the mandate if they are handling orders in excess of a certain threshold. If the order is under that threshold–say, 5,000 shares–then the orders must be exposed to the light of day.
The clarification to the rule is expected to pass, said Alison Crosthwait, director of research at Instinet in Canada, despite mixed opinions on the matter. She said regulators value a transparent market above all else and a minimum size requirement is consistent with that thinking. A proposal is expected by the end of the second quarter and the revision should go into effect in the second half of the year.
A minimum-order-size rule could stymie growth in the nascent dark pool space, especially for U.S. based brokers that want to set up shop in Canada.
Such is the case for Credit Suisse, which has been considering launching a Canadian dark pool, said Dmitri Galinov, head of liquidity strategy for Credit Suisse’s Advanced Execution Services group, operator of the Crossfinder dark pool.
"We have not finalized anything," Galinov said. "We will continue to monitor the regulatory landscape in Canada and revisit the idea of proceeding with a dark pool there after the final rule publishes from regulators and Credit Suisse has an opportunity to view it."
Citi is also looking into establishing a crossing network in Canada. Tim Reilly, managing director in Citi’s North American electronic execution business, told Traders Magazine the firm was exploring the idea but that it has to work through the county’s regulatory environment to make it a reality.
"Yes. We are considering introducing a crossing network there, but nothing is imminent," Reilly said. "We’re not talking about opening anything before the middle of the year."
The idea of minimum order size has drawn mixed reviews. The regulators’ position paper received 23 comment letters. Firms such BMO Nesbitt Burns and TD Asset Management were largely opposed to the idea. The TSX and trade group the Portfolio Management Association of Canada were among those in favor.
Dark pools are not big in Canada. There are only two in operation–both with U.S. origins–but there are some waiting in the wings from several bulge firms. Alpha will release a revised dark pool in the second quarter. Given the trend in Canada toward more use of algorithms, dark pools are seen as a natural development there.
Dark pool trading accounts for about 2.7 percent of the market average 634 million shares that trade per day in Canada, according to market research consulting firm Forefactor. By comparison, 12 to 13 percent of total U.S. trading volume comes from dark pools and crossing networks, according to a dark pool survey compiled by Rosenblatt Securities.
The first Canadian dark pool is run by ITG via its TriAct Canada Marketplace subsidiary. According to ITG, it trades 1.5 percent of total daily volume. The other dark pool, Liquidnet Canada, specializes in providing block liquidity to the buyside. It sees less than 1 percent of total daily volume.
The decision to reroute an order based on specific size criteria–and not by the choice of the customer placing the order–is the most controversial, said Doug Clark, managing director at ITG Canada.
"We as a firm believe that if a client wants to impose minimum sizes on their own orders, or place them in such a way that they interact with orders of minimum size, that’s a far better solution than the regulators telling us what size orders can go into dark pools," Clark said.
The rule will not affect the upstairs trading market in Canada, which accounts for about 20 percent of daily volume.