Canadian regulators have passed new rules governing dark pools in Canada, eliciting mixed responses from market participants, with no discernible consensus from either the buyside or sellside, or from the dark pools themselves.
The main goal of the rules, according to regulators, is similar to the U.S. concept of a "trade-at" rule. If a trade is to be executed in the dark, it must offer meaningful price improvement over the displayed market’s price.
In the U.S., the idea of requiring internalizers such as wholesalers and dark pool operators to pay more for orders than they already do has been kicking around for a couple of years. The debate – has centered on how much a broker or wholesaler would have to price-improve an order to internalize it or be forced to send it to a public exchange. U.S. wholesalers, broker-dealers that execute retail orders, are vehemently opposed to trade-at.
Under the new Canadian rule, besides providing meaningful price improvement, regulators laid the groundwork for a minimum trade size for off-board trades. Both the price-improvement rules and the minimum-trade-size amendment are supposed to keep trading focused in the lit market, which is historically important to Canadians, as well as to promote fairness between smaller retail and larger institutional order flow.
One buysider was OK with the new amendments. Michael Thom, head trader at Vancouver-based Genus Capital Management, said regulators are on the right track in defining meaningful price improvement and in considering a minimum trade size for dark orders. This type of approach, implementing some rules and publicly stating they are only laying the groundwork for others, is beneficial for the market, he added.
"I think they (regulators) struck a balance here," Thom said. "These rules are not going to negatively impact me and will continue to let me trade in the dark where I want to. Did they institute exactly what I wanted? No. But they struck a good balance and are letting the market adjust and then come back and see what the rules’ effects are. Incremental change is good."
Liquidnet, which operates a dark pool in Canada, is also accepting of the rules. Robert Young, president of Liquidnet Canada, said the rules preserve the appropriate protections for institutions seeking to execute large block orders in dark venues.
See Chart: Canadian Trading Volume
"The regulators want to constrain U.S.-style internalization in dark pools, thereby avoiding greater fragmentation of the Canadian markets," Young said. "These rules do so while allowing institutions to trade in size without constraint."
And one broker-dealer was upbeat on the rules as well, despite not knowing all the details on just what the minimum-trade-size requirement would be set at.
"I think that if the new rules curtail order-sniffing in dark pools, then in my opinion that’s good," said James Duncan, director of international trading at Canaccord Genuity. But, he added, the reality is that no one knows what the minimum size will be, and therefore the rule’s impact could positively or negatively affect market activity.
"If the rule curtails the use of dark order types of small size used to gather information on larger client orders to trade ahead and or trade, then the rule would be beneficial to the overall market structure," he said.
Dark pool trading in Canada reached $13 billion in March, the highest total ever and twice the amount seen last March, according to Thomson Reuters. The Investment Industry Regulatory Organization of Canada–, the country’s leading regulator-reports dark trading is roughly 7 percent of total daily market volume in Canada. That’s up from 2.2 percent in 2011. In the United States, dark pools account for 13 percent of market volume, according to Rosenblatt Securities.
The new changes are part of the Universal Market Integrity Rules, Notices 11-0225 and 23-311. They were approved April 13 and go into effect Oct. 10. The rules, three years in the making and written by IIROC and the Canadian Securities Association, were meant to clearly define "better price," to ensure investors receive meaningful price improvement, said Wendy Rudd, senior vice president of market regulation and policy at IIROC. The regulators deferred on the rules’ most contentious aspect: the minimum trade size requirement.
Setting a minimum size requirement, Rudd noted, would not be done without a greater review of real-time order, message, cancellation and trading data, as well as more consultation with others. If the data need further analysis, the regulators will issue a formal request for comment.
Despite the several supporters of the rule, it still has plenty of detractors.
Among the leading critics is Doug Clark, former chair of the Canada Security Traders Association and head of market structure at ITG Canada. ITG operates Match Now, the country’s largest dark pool.
"Most of the buy- and sellside firms I have spoken with are upset with the final rule," Clark said. "The comment letters throughout the process clearly stated a need to keep vibrant dark pools as a meaningful counterbalance to the lit markets. Any rule that has the potential to hamper dark pools needs to be well considered and offer alternatives to investors looking to avoid such gaming. This rule is neither well considered nor does it offer any alternatives."
Morgan Stanley is also opposed to a minimum price-improvement requirement. In an Oct. 27, 2011 comment letter to the regulators, it wrote, "We therefore do not advocate adoption of a minimum price-improvement requirement solely for interaction with small-sized dark orders, and especially not based upon unsubstantiated reasoning that it may possibly boost investor confidence."
Furthermore, the broker wrote that Canada’s more stringent approach to dark pool regulation than in other countries could lead to order flow leaving the country for other jurisdictions. ITG’s Clark agrees there could be an order exodus. "The minimum price improvement may result in clients posting more of their dark orders on U.S. venues that do not have this limitation," Clark wrote in a comment letter last October.
IIROC has separately proposed "anti-avoidance" provisions which would prevent participants from shipping orders outside of Canada to avoid these new dark regulations. Rudd said IIROC is open to alternative ways to address the concern.
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