Fearing the impact on the Canadian equities markets if too much retail trading is diverted south of the border, regulators are proposing a rule that would curb that flow. But the cure could be worse than the disease.

Over the past six months, Canadian securities regulators have become increasingly concerned about the prospect of brokerage firms sending their retail order flow for interlisted stocks to the U.S. to be traded in dark pools. The fear is that by essentially packaging up much of the retail order flow and selling it to U.S. wholesalers for execution in U.S. dark pools, Canadian dealers may be engaging in regulatory arbitrage – the Canadian rules for dark pools are tougher than they are in the U.S. – thereby undermining Canadian rules designed to protect lit markets.

The worry is that the migration of this trading southward could lead both to lower-quality executions for Canadian investors and the undermining of the overall health of the Canadian equities market.

The Canadian Securities Administrators (CSA) issued a statement last December, highlighting their concerns about this trend. And, in late January, the Investment Industry Regulatory Organization of Canada (IIROC) proposed to address the problem head on by reviving a rule that would prevent small orders from being routed south of the border and executed outside of transparent exchanges.

Now, however, the Canadian industry is sounding the alarm about that proposed rule, warning that the rule amounts to protectionism that could harm Canadian markets, particularly small dealers and asset managers. The concern is that, by blocking retail order flow from being executed in U.S. dark pools, regulators are making these orders captives of the more expensive, less liquid, less efficient Canadian market.

The IIROC proposals also may make retail investors more vulnerable to high-frequency traders who can generate profits easily by arbitraging retail orders in Canada against better-priced U.S. dark-pool executions. And, such change will make Canada a less attractive destination for foreign orders.


“We see these proposals as protectionist measures that remove natural competitive pressures by limiting orders from routing to the U.S. in their search for best execution, while doing nothing to address the reasons that orders may seek to execute in the U.S. in the first place,” argues Scotia Capital Inc. in its comment on the proposals. “Instead of addressing the underlying problems, these changes will make things worse by once again raising costs of execution in Canada and lowering the competitiveness of our market.”

These sentiments are reflected in a number of comments, particularly from large, bank-owned dealers. Indeed, the comment from the Investment Industry Association of Canada (IIAC) also characterizes IIROC’s proposals as “a protectionist measure” that, it warns, will ultimately harm Canadian markets and investors: “This protectionism will drive up costs, restrict available options for investors and hamper the competitiveness of the Canadian investment industry.”

The IIAC comment also warns that such measures could have a disproportionate effect on smaller Canadian dealers that don’t have U.S. affiliates through which to route southbound orders.

The consensus seems to be that regulators would be better off addressing the underlying motivation for firms to route orders to the U.S. in the first place – that is, the Canadian market is a more expensive place to trade.

In fact, regulators are considering possible market structure reforms that would try to address concerns about the costs and inefficiencies of the Canadian market structure.

In May 2014, the CSA proposed amendments to the order protection rule that would limit its application to markets with significant market share. The CSA also proposed both the introduction of a process to assess the fairness of market data fees and implementing a cap on trading fees. And, the regulators pledged to study a possible ban on so-called “maker-taker” fee structures.


The consultation period for those proposals wrapped up last autumn. The CSA indicates that it “is still considering the comments received and the options for moving forward.”

The other major target of dealers’ ire is the Canadian rules for dark pools, which are blamed as an underlying driver of the move to embrace U.S. dark pools. Back in 2012, regulators adopted a rule designed to boost trading on transparent marketplaces by requiring that orders that trade in the dark must receive meaningful price improvement. That rule seemingly has worked as intended by curbing dark volume and preserving the role of transparent markets.

Yet, in doing so, the rule also eliminated a valuable source of competition in the Canadian market and enhanced the appeal of routing retail orders to U.S. wholesalers. Reforming, or even scrapping that rule altogether, could be contemplated as a way of addressing the regulators’ concern about southward retail order flow.

IIROC is studying the feedback generated by its latest proposal. Notes Wendy Rudd, senior vice-president, market regulation and policy, at IIROC: “Further work is underway to foster constructive dialogue on the issue of orders for Canadian securities being routed to the U.S. and the best approach to maintaining healthy and competitive Canadian markets.”

Trading these days is such a complex, zero-sum game that the finest details of the rules can have outsized implications for various market players. The revival of IIROC’s anti-avoidance provision is inflaming industry tempers.

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