Canadian Market Adjusts to Dark Rules

Terry Flanagan

More than six months after Canada implemented new rules to rein in dark trading, there are some indications that market participants are acclimating.

“When the dark rules took effect we first saw a decline in dark, but there has been an uptick in the past two months or so,” said Kevin Sampson, vice president of business development and strategy for TMX Group. “Liquidity providers participating in dark pools are having an opportunity to see how order flow patterns adjust, and update their routing strategies.”

In October 2012, the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada implemented rules governing dark liquidity. Key aspects to the regulation include visible order priority, meaningful price improvement, and minimum size.

“We are supportive of the dark framework put in place by regulators. We have always felt it’s appropriate to have a framework which first and foremost encourages transparency and a visible process for price formation,” Sampson told Markets Media. “The framework put in place is not inconsistent with core principles of the Canadian marketplace previously. Our allocation methodology is price-broker-time priority as opposed to price-time priority — this encourages on-book activity.”

Dark trading in Canada declined to an estimated 2-3% of equity trading volume after the October 2012 rule changes, from about 5% previously. The recently observed uptick suggests that dark trading may rebound to earlier levels.

“Dark trading has a role to play. It’s an option that serves a purpose for some market participants,” Sampson said. “Canada’s dark rules do not preclude dark trading – there are still a variety of dark models out there that give investors a choice. So the rules allow for a framework, but not the degree of fragmentation, costs, or non-transparency” that can be associated with higher levels of dark trading, he said.

TMX continues to support the regulations regarding dark trading, but more time is needed to fully assess the framework, Sampson noted. “Dealers take a while to adjust…As far identifying impact and nuances, it really is too early. We still have some work to do in having both the sell side and buy side become more educated and comfortable with the use of dark trading.

Sampson said some foreign traders and investors relayed that they like Canada’s market structure for its transparency, clear rules, and lack of complexity compared with the U.S. Displayed liquidity in Canada is WYSIWYG, or what you see is what you get, he noted.

“We definitely would be concerned” if off-exchange volumes were at U.S. levels of as much as 40%, Sampson said. “Fragmentation has a cost, and it’s incumbent on the industry as a whole to ensure that the benefits of fragmentation are commensurate with the costs…Excessive dark fragmentation creates almost a two-tiered market structure.”

Other Canadian market participants are more constructive on fragmentation, noting that an increased field of trading-venue providers fosters competition and innovation. There is also the point that price improvement may be left on the table.

“Although the dark rules have been quite restrictive to liquidity providers it has not been counterproductive,” said Sean Debotte, director of business development at Omega ATS. “Most of the previous dark liquidity has migrated back to lit venues where they participate in price discovery. The primary detriment is that liquidity consumers are now crossing the spread more often and not able to take advantage of small dark price improvements.”

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