IIROC rethinks the role of "order execution only" firms

By James Langton | Mid-February 2017

The discount brokerage business is in an uproar over proposed new regulatory guidance. Firms such as Toronto-based Questrade Inc. worry the proposal will shift some of the basic pillars of the existing industry and fundamentally alter the discount brokerage sector regarding the services these firms can offer to their clients.

Last autumn, the Investment Industry Regulatory Organization of Canada (IIROC) proposed new guidance for so-called "order execution only" firms, or discount brokers, which are favoured by do-it-yourself investors. The clients use a dealer to process their orders but don't rely on them for investment advice.

The guidance aims to set out IIROC's expectations for these firms in a world that has evolved a great deal since discount brokers first came on the scene some 20 years ago.

Among other issues, the regulators are grappling with what constitutes "advice" in an environment of increasingly sophisticated online tools, such as asset-allocation generators, automated alerts, stock-selection filters and model portfolios. The new guidance aims to set out IIROC's views on exactly what these firms can offer - in terms of accounts, products, and decision-making tools - under the existing regulatory framework.

But firms are warning that complying with the details of these proposals from IIROC would profoundly alter their businesses and that, in the process, the regulators are effectively redefining what it means to give advice.

One of the central criticisms is that the guidance would delineate what constitutes a "recommendation" to a client. The prevailing regulatory framework for discount brokers is premised on the idea that discount brokers do not provide advice to their clients, so they don't have to ensure the suitability of their orders. This role differs from that of automated asset-allocation services, or robo-advisors, which do explicitly provide advice to clients and are regulated either as portfolio managers or full-service dealers.

But technological innovation is blurring the traditional concept of what constitutes advice, and regulators are striving to keep up. One of the basic issues driving the revised guidance is the question of whether discount brokers are straying into the business of giving advice by providing model portfolios to their clients.

IIROC's proposed guidance concludes that this practice can amount to providing advice, which discount brokers are traditionally prohibited from doing. It also aims to allow the practice to continue, subject to certain limitations.

This approach does not sit well with some full-service firms. Some have complained that the discount brokers are enjoying the advantage of a tilted playing field by being allowed to provide clients with a form of advice without having to bear the compliance costs of ensuring the suitability of that advice, as full-service firms are required to do.

The Ontario Securities Commission's Investor Advisory Panel (IAP) also has concerns with the fact that the IIROC guidance would establish what constitutes "recommendations" and "advice" from a regulatory perspective. The IAP says this could affect not only the playing field between full-service firms and discount brokers, but also between the mutual fund business and the exempt market.

The IAP, in its submission to IIROC, states: "IIROC is proposing a definition of 'recommendation' and it is doing so not through rule making, which must be considered and approved by the [Canadian Securities Administrators], but through guidance. This is unprecedented and could have serious and unintended consequences for the availability and nature of advice for Canadian investors."

At the same time, discount brokers say that the proposed new guidance would affect their businesses significantly by requiring them to screen their clients as part of the account-opening process to determine whether to take a client, and require them to establish the sorts of products and accounts those clients should be able to use. For example, firms would be expected to decide whether a client should have access to complex products or be allowed to open a margin account.

"The benefit of this approach," the proposed guidance states, "is that it fosters investor protection by ensuring that ... clients do not have access to inappropriate products and/or account types."

Yet, various firms argue in their submissions to IIROC that requiring them to engage in this sort of analysis is anathema to the discount brokerage business.

For example, Questrade states in its comment that this approach, "fundamentally contradicts the reasons why a client chooses to use [a discount broker]."

The firm points out that clients who opt to deal with discount brokers want to "engage in their own research, make their own decisions about investing and are not interested in being told what is appropriate and what isn't appropriate."

Moreover, investors use discount brokers because they are less expensive than full-service advisory firms. Questrade warns that requiring firms to assess clients will raise costs and prevent them from providing a low-cost alternative. If the requirements of this proposed guidance are introduced, it says, "the [discount brokerage] model will not likely survive in its current form as it will have to be transformed to a point where it would no longer resemble any current model."

Firms argue that this approach also will add uncertainty for dealers, increase litigation risk and tempt investors to "game" the account-opening process to preserve their access to a wide range of products and accounts, among other negative side effects.

Another major criticism levelled by discount brokers at the proposals is that if regulators curb the sorts of information and tools that firms can provide to their clients, those clients could resort to basing their investing decisions on other, less reliable sources of information, hampering their decision-making.

"Providing a wide range of documentation and products is to the benefit of the client and this guidance, if implemented, will not protect the investor and is therefore not in the best interest of the client," the Investment Industry Association of Canada states in its comment on the proposals.

"We doubt the [discount brokerage] model and the [discount] industry would survive the changes proposed in this guidance."

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