Alternative trading systems in Canadian equity markets have re-emerged over the past few years. Six electronic trading platforms — Pure Trading, Liquidnet Canada Inc., MatchNow, BlockBook, Instinet Canada Cross and Omega — have geared up; several additional systems, including ATX and Project Alpha, expect to begin operations soon. The recent entry of these new systems reflects several factors: demands for specialized trading venues; competitive pressure to lower fees and data costs; and the presence of these trading systems internationally.

The advent of these systems in Canada has renewed the scrutiny of markets by regulators, with the focus on best execution rules, trade-through restrictions, market access, market transparency and other consequences of market fragmentation. But at the moment, there is more heat than light: participants are demanding greater clarity, and regulators continue to deliberate on the issues without introducing new rules designed to preserve liquidity and ensure investor access. Without clear direction from the regulators, these electronic markets risk fragmenting into independent liquidity pools, with deteriorating pre-trade and post-trade transparency and restricted investor access to best price, leading to the loss in overall market liquidity and efficiency.

The central feature of market integration is an effective trade-through rule that requires orders to be routed to the marketplaces with the best prevailing price, giving investors confidence that their “buy” or “sell” orders will be the first in line to be filled. Although no decision has yet been made on whether dealers or marketplaces will be ultimately responsible for routing orders to comply with the trade-through rule, the onus now falls entirely on the dealers.

This approach is inconsistent with that in the U.S., where the Securities and Exchange Commission has imposed responsibility on the marketplaces for complying with its version of the trade-through rule. Here in Canada, unless there is a decision soon, dealers operating under the existing rules will have no choice but to buy or build the technology to route orders electronically in real time across competing marketplaces to fill orders at the best prevailing prices.

These trade-through technology costs would be ultimately passed on to the investor. In the aggregate, they will be higher per transaction — due to the number of dealers that must incur these costs — than if incurred by marketplaces. Even regional dealers with relatively small order flow and limited scale would have to invest in independent order-routing technology. Rather than eight to 10 routing systems for the Canadian market, there would be 15 to 20 times that number.

And not only order-routing technology would be required; systems to handle complex order management in multiple markets and computer analytics for stock dealing also would be necessary.

Regulators have not yet placed minimum requirements on new marketplaces in terms of technology protocols to interface with investment dealers and clearing systems for order routing and the settlement of securities. As a result, dealers face additional costs in linking to new markets, as well as making critical judgments on whether and when the liquidity threshold of a particular market merits linkage to order-routing systems.

The higher transaction costs that are the outcome of these technology expenditures will reduce client order flow, particularly for orders from small dealers, and adversely affect the price discovery process and market efficiency. Further, it is possible that small dealers confronted with these significant costs will make an economic decision to withdraw from secondary equity markets.

Moreover, the regulatory delay in designating a central information processor to link equity marketplaces by providing consolidated real-time pre-trade and post-trade data could further weaken transaction flows in equity markets, as transaction flows decline in response to the opaqueness of pre-trade information among marketplaces. There is no certainty, as independent electronic trading systems gain market share, that competitive market forces will respond with effective consolidated cross-market price transparency.

Regulators should move quickly to provide clear policy direction in response to the structural changes that are now taking place in Canadian equity markets. If market transparency and data consolidation in a fragmenting marketplace are left simply to competitive forces, the efficiency and competitiveness of our domestic equity markets will be put at risk.

The first priority should be for regulators to implement a comprehensive trade-through rule for equity marketplaces that requires them, as a condition of approval, to have the technology to route orders to competing marketplaces offering better prices. The second priority should be to establish an information processor for equity marketplaces and mandate stock exchanges and electronic trading systems to connect data feeds to this market hub. The information processor would sort the cross-market data in real time to provide reliable consolidated information about the best pre-trade prices.

With these changes, we will be able to begin building a brave new world of electronic trading that creates value for the investing public and our equity markets.

Ian Russell is president and CEO of the Investment Industry Association of Canada.