Legal Updates

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Update

Wednesday, July 6, 2016

On April 7, 2016, the Canadian Securities Administrators (the “CSA”) published amendments to National Instrument 23-101 Trading Rules (“NI 23-101”) and its companion policy 23-101 CP (the “Amendments”). The Amendments are part of an ongoing review by the CSA of marketplace (i.e., securities exchanges and alternative trading systems) regulation, innovation and competition in Canada, which has evolved in the context of increasing use of high-speed technology in the field of securities trading, including high-frequency trading (“HFT”).

The Amendments consist primarily of the introduction of market share thresholds to the order protection rule (“OPR”)[1], as well as changes that address intentional order processing delays known as “Speed Bumps”. In addition, the Amendments implement a cap on active trading fees. The Amendments also contain the CSA’s discussion of other related initiatives such as regulating market data fees and a pilot study on the prohibition of payment of rebates by marketplaces.  

The Amendments are part of the CSA’s response to concerns raised by market participants with respect to inefficiencies and costs associated with the current market structure, including costs associated with OPR compliance. While the CSA’s measures address some of these concerns, the Amendments also underscore the complexity and interconnectedness of the markets which makes regulation difficult to implement in this area.

The Amendments, with the exception of the market share threshold, come into force on July 6, 2016. Amendments relating to the market share threshold will come into force on October 1, 2016.

Key Amendments

Market Share Threshold, Speed Bumps and Protected Marketplaces

The Amendments introduce a 2.5% market share threshold to determine whether orders displayed on a given marketplace will be protected pursuant to OPR. The market share of each marketplace is calculated based on the average share of the adjusted volume and value traded (both equally weighted) over a one-year period.

A marketplace that has at least a 2.5% market share will be considered a “protected marketplace”, and orders displayed on that marketplace will be “protected orders” for the purposes of NI 23-101. Orders displayed on a marketplace that fails to meet the threshold will not be considered “protected orders”, meaning that orders displayed on other protected marketplaces may execute at inferior prices notwithstanding that better-priced orders may exist on the unprotected marketplace.

The CSA have stated that introducing a market share threshold will provide flexibility for market participants in determining if and when to access marketplaces that fall below the threshold and consequently are not subject to OPR. Market participants have long raised the issue that OPR requires them to establish and maintain connections to all marketplaces and to obtain their market data (no matter how small or how infrequently the participant actually trades on such marketplace), which is expensive and ultimately drives up the total cost of trading. Other stakeholders have expressed concerns that imposing OPR requirements on some marketplaces but not others is inequitable on a competitive level (since OPR protection is generally seen to attract trade volume to the marketplace) and would introduce complexities in how market participants must interpret market data and make trade routing decisions. Ultimately, the CSA found that the introduction of a market share threshold was appropriate.

The Amendments also specify that where a marketplace has introduced a “Speed Bump” that results in the inability to provide for an immediate execution against displayed volume, the marketplace would not be considered a protected marketplace. Speed Bumps have been introduced in two marketplaces in Canada, the Aequitas Neo Book and TSX Alpha, each with the aim of slowing certain order flow to influence speed-sensitive trading, including HFT. The CSA have stated that where order processing delays are systematically built into the functionality of a marketplace, it is not reasonable to require market participants to route orders to that marketplace for OPR compliance.

A list of protected and unprotected marketplaces is available on the website of Investment Industry Regulatory Organization of Canada, here.

Trading Fees

The Amendments implement an active trading fee cap on continuous auction trading in equity securities and exchange-traded funds of $0.0003 per share or unit for securities priced at or above $1.00 and $0.00004 per share or unit for securities priced below $1.00. The CSA state in the Amendments that while the cap for securities priced at or above $1.00 is higher than fees currently charged by most Canadian marketplaces, it was necessary to settle on this amount to maintain parity with U.S. regulation. In light of the significant trading activity in securities that are listed in both Canada and the U.S. (“Inter-Listed Securities”), the CSA believe that parity of trading fees is necessary for competitive reasons to avoid a shift in liquidity to U.S. marketplaces and widening spreads on Canadian marketplaces.   

On April 7, 2016, the CSA published a separate notice and request for comment which outlines a proposal to implement a lower cap of $0.00017 per share on non-Inter-Listed Securities, recognizing that the same concerns are not present where securities are listed only in Canada.

Market Data Fees

In an effort to control the cost of market data charged by marketplaces, the CSA announced in the Amendments that they will formally adopt their “Data Fee Methodology”, which estimates a fee or fee range for market data for each marketplace based on its contribution to price discovery and trading activity. Marketplaces will be required to submit their market data fees to the CSA on an annual basis, and to justify these fees in the context of the Data Fee Methodology results. A common concern among market participants has been that market data is not subject to sufficient competitive pressure to reduce cost, in part due to the fact that market participants are in effect required to obtain comprehensive market data in order to comply with OPR compliance obligations.

Pilot Study on Prohibition of Rebates

The payment of rebates by marketplaces has long been suspected by the CSA and other stakeholders as potentially leading to lower market quality, including increased fragmentation and segmentation of order flow, transparency issues and increased intermediation, as well as causing conflicts of interest for dealer routing decisions.

In the Amendments, the CSA announced that they will not pursue a proposed study to examine the impact of disallowing the payment of rebates by Canadian marketplaces, citing the potential negative consequences of proceeding without a concurrent U.S. study. In particular, the CSA have concerns that including Inter-Listed Securities in the study without a concurrent U.S. study may lead to a shift in liquidity to U.S. marketplaces. On the other hand, the CSA also do not believe that a study that excludes Inter-Listed Securities would be meaningful in light of the significant trading activity in Inter-Listed Securities that would be excluded. The CSA indicated that they will continue to monitor regulatory trends and would consider conducting a joint pilot study with the U.S. if and when such opportunity arises.

Conclusion

The Amendments outline the CSA’s first formal departure from the application of the OPR, which was initially implemented to, among other things, enable consolidation of a fragmented marketplace and foster competition. It is interesting to note that the advent of “Speed Bumps” is the direct result of competition among marketplaces attempting to differentiate their trade matching functionality to appeal to different types of order flow, and that this feature now disqualifies a marketplace from obtaining “protected market” status. Marketplaces that choose to pursue a “Speed Bump” feature will have to do so without the benefit of OPR protection. In addition, the application of a market share threshold will act as an additional barrier to entry for prospective new marketplaces, since any new marketplace will effectively be handicapped by its “unprotected marketplace” status until it is able to accumulate sufficient market share to meet the threshold. In each case, by designating both protected and unprotected marketplaces the CSA may have created a more complex market structure.

Also notable is the fact that, due to the significance of Inter-Listed Securities to the Canadian marketplace, certain challenges may only be addressed with cooperation of U.S. regulators, otherwise liquidity may evaporate from the Canadian market.

This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.

If you would like further information regarding the issues discussed in this update or if you wish to discuss any aspect of this commentary, please feel free to contact us.



[1] OPR is a marketplace obligation which generally requires that each marketplace establish, maintain and ensure compliance with written policies and procedures that are reasonably designed to ensure that all immediately accessible, visible, better-priced limit orders are executed before inferior-priced limit orders and are not traded through.