Regulators End Busy Year

Terry Flanagan

Rules on dark orders, dark pools, broker preferencing and internalization to affect market structure.

Regulators are closing out a busy year, during which they’ve proposed rules that could significantly alter the state of trading, according to a report by Investment Technology Group.

In 2011, regulators have issued or are preparing for release proposed rules for dark orders and dark pools, electronic trading and direct access to marketplaces, broker referencing and internalization.

“Our regulators have an enormous number of market micro-structure issues to deal with in the coming year, transparency in the OTC markets being one of the most daunting,” Renee Colyer, president of Forefactor, told Markets Media.

Both the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada (IIROC) have been working in unison to develop new rules for both dark pools and dark order types.

The most recent proposal—Notice 23-311—was released on July 29, 2011, and contains several key components. The full process of accepting comments, publishing a final rule, and implementation will likely run through the summer of 2012, according to ITG.

Passive fully hidden orders must meet or exceed a minimum size threshold. This proposal is actually a place holder that the regulators are trying to get approved, so if they decide a minimum size is required, they can implement it relatively quickly, according to ITG.

The proposal would allow IIROC to set a minimum size for any order entered passively into a dark pool or using a fully hidden order in a lit venue. Currently, it’s believed that the minimum size would likely be 50 board lots for all stocks regardless of the liquidity of price of any given issue, according to ITG.

On any given venue, lit liquidity get priority over dark liquidity. This would ensure that the matching algorithm at each venue prioritized visible orders when a marketable contra side order was available.

Using the TSX as an example, an inbound marketable order would first with with any visible liquidity, then would match with the hidden portion of any iceberg orders, and then with any fully hidden orders at each price level.

The regulation would mandate minimum price improvement by dark orders. Regulators are proposing that dark orders would need to price improve over the NBBO by one full tick.

Often compared to the trade-at rule in the U.S. markets, the idea is to prevent dark orders from jumping in front of visible quotes by some fraction of a tick, and potentially de-incenting investors from placing visible bids and offers in the lit market, according to ITG.

The proposed Electronic Trading Rules (NI 23-103), published on April 8, 2011, will likely undergo revision before becoming finalized next summer, ITG said.

The proposal ensures that any participant that is going direct to market, without first touching the sponsoring broker’s infrastructure, will be registered with Canadian regulators and subject to audits, credit checks and potentially enforcement.

The CSA and IIROC will both be addressing broker preferencing and internalization in the coming months.

Broker preferencing has been part of the Canadian market since it first moved into electronic matching and has been one of the most controversial features in the marketplace. It’s widely believed that regulators will attempt to outlaw broker preferencing, ITG said.

Regulators are also opposed to broker internalization. They’ve given guidance that any dealer that uses automated systems to match orders and then print them elsewhere will be deemed a marketplace and required to register as such, and have used language in their proposals on dark orders to underline their goal of avoiding an internalization-heavy marketplace, said ITG.

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