Canadians Favor Regulated Dark Liquidity

Terry Flanagan

Comments suggest expansion of Canadian dark pools should be done very cautiously

Canadian stock market participants mostly favor tighter restrictions on dark liquidity than those in the U.S., where the highly fragmented market is nearly 30% dark, but the Investment Industry Regulatory Organization of Canada’s (IIROC) proposed amendments go too far for all but investor advocates.

Comments were due on the UMIR Rule 6.5 proposal Oct. 27, with most calling for regulators to accumulate more evidence before proceeding and offering their own tamed -down versions of key proposal elements.

One of the few fully supportive comment letters was submitted by the Canadian Foundation for Advancement of Investor Rights (FAIR), a non-profit organization that advocates for strong investor rights.

“FAIR Canada believes these principles are particularly important for individual investors, who may not understand dark pools, or be in a position to take advantage of them or other specialized trading services,” the comment letter says. It adds that users of dark liquidity should not be allowed to take advantage of individual investors who must use markets displaying visible quotes.

RBC Global Asset Management was also supportive, saying a minimum size threshold for dark orders was appropriate for both passive resting order as well as active ones, and that visible orders should have execution priority over dark ones.

Sell-side participants, however, had more nuanced views, ranging from maintaining the status quo—still more restrictive rules for dark liquidity than those south of the border—to less strict versions of IIROC’s proposals.

For example, Edward Jones, a brokerage focusing on retail investors, holds a very different view. Echoing a common complaint among the 13 submitted comment letters—mostly from brokers—the firm’s general counsel and chief compliance officer, D.J. Burwell,  writes, “We believe the proposed rules are overly burdensome for executions that only result in 3% of market volume.”

TD Securities, the country’s largest broker, calculates electronic dark liquidity represents closer to 5% of Canadian stock market volume, significantly less than the13.6% market share of alternative trading systems registered in the U.S. Its letter commends regulators for striking a fair balance so far between the needs of retail and institutional investors for dark and visibility liquidity “while avoiding the extreme fragmentation which has occurred in the U.S. dark market.

“However, we are concerned the proposed amendments with regard to minimum order size and price improvement for dark liquidity are overly restrictive…” write David Panko, managing director of TD Securities’ automated trading group. TD Securities estimates total dark liquidity in Canada, including traditional upstairs trading, making up 20% of the market, while the total in the U.S. is 28%.

Panko argues that the main driver behind growth in dark liquidity has been the advent of the maker-taker pricing model, in which liquidity providers—typically electronic trading firms—are rebated for limit and marketable limit orders, shifting prices away from the visible quotes and distorting markets. In fact, the $.001 price improvement Canada already requires of dark orders, and the up to $0.004 market centers currently offer, serves to put liquidity takers — most investors — on more equal footing with liquidity providers, he says.

The $0.01 price-improvement requirement in the proposal (and $0.05 improvement when the bid and offer spread is only $0.01 wide), Planko says, will make it “uneconomical for participants to provide two-sided liquidity on dark venues since the bid-offer spread is eliminated.” There is no such price improvement requirement in the U.S., where many dark orders are executed at the national best bid or offer (NBBO).

Scotia Capital largely agrees, noting that the maker-taker fee models have driven up costs for smaller orders, pushing them avail more of dark liquidity. But while it is concerned about growing dark liquidity’s impact on the integrity of quotes, Canada’s existing requirements that alternative trading systems (ATSs) be accessible to all market participants and that participants pay a penny tick to internalize orders have so far kept negative consequences in check.

“Currently, our view is that the benefits of dark liquidity outweigh the costs given the moderate level of usage in Canada,” writes Evan Young, head of electronic execution services and director of institutional equity at the firm.

Young notes that Scotia Capital was initially supportive of Iiroc’s initiative but now is more inclined to maintain the status quo. That includes postponing any significant minimum size on block orders to remain dark (NBBO), a consideration regulators had pegged at 5000 shares earlier in the regulatory process, until there is more evidence that dark liquidity is truly harming the market.

“We continue to strongly prefer transparent markets and are concerned that excessive dark order usage would impact the price discovery process,” Young writes. “However, we believe that at current usage levels dark orders represent a reasonable compromise to deal with high maker-taker trading fee structures and resultant excessive intermediation.”

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