On April 30, 2015, the applicable securities regulatory authorities approved amendments to UMIR respecting the definition of Basis Order (the “Amendments”).1
The Amendments broaden the definition of Basis Order to specifically include Exempt Exchange-traded Funds2
(“ETF”). IIROC believes that the execution of an ETF as a Basis Order at a price derived from the execution of the underlying component securities is consistent with the principles supporting Basis Orders generally.
The Amendments will:
- provide that an ETF may be traded as a Basis Order at a price derived from the prices achieved from the executions of the underlying components where the executions represent at least 80% of the component securities weighting of the ETF, and
- providing that a basket of listed securities may be traded as a Basis Order where the execution price is derived from the price achieved from the execution on a marketplace of an ETF where the basket of listed securities comprises at least 80% of the component securities weighting of the ETF.
IIROC does not expect the Amendments to cause any technological impact on Dealer Members.
The Amendments are effective immediately.
- 1Reference should be made to IIROC Notice 14-0077 – Rules Notice – Request for Comments – UMIR – Proposed Amendments to the Definition of Basis Order (March 27, 2014).
- 2UMIR defines an Exempt Exchange-traded Fund to mean a mutual fund for the purposes of applicable securities legislation, the units of
(a) are a listed security or a quoted security; and
(b) are in continuous distribution in accordance with applicable securities legislation
but does not include a mutual fund that has been designated by the Market Regulator to be excluded from this definition.
To date, IIROC has not designated any mutual funds to be excluded from this definition.
Background to the Amendments
Basis Trades were introduced on the Toronto Stock Exchange (“TSX”) in 2003 as a method of trading to reduce exposure by ensuring that a price achieved by one or more derivative transactions is reflected in the prices of the related and offsetting transaction or transactions. The use of Basis Trades allowed a Participant to precisely offset derivative risk. The TSX defines a Basis Trade to mean:
- A transaction whereby a basket of securities or an index participation unit is transacted at a price calculated in the prescribed manner which represents the average accumulation (or distribution) price of the position, subject to an agreed upon basis spread, achieved through the execution of a related exchange-traded derivative instrument, which may include listed index futures, index options and index participation units in an amount that will correspond to an equivalent market exposure.
This definition of Basis Trade remains in the TSX Rule Book and is in force today. Policy 4-107 of the TSX Rule Book further requires that a Basis Trade must comprise at least 80% of the component share weighting of the related execution through which the Basis Trade is priced.
Consideration of Index Participation Units
The TSX definition of Basis Trade provides that the price at which a Basis Trade may be executed on the TSX can be derived from the prices achieved through the execution or executions of a derivative instrument, which for the purpose of the definition, specifically include an index participation unit.
Index participation units were originally listed on the TSX in 1990 in the form of TIPS and HIPS which tracked the exact performance of the TSE 35 Composite Index and the Toronto 100 Index respectively. Effectively, these index participation units were the precursor to today’s ETFs.
Prior IIROC Guidance
In 2003, Market Regulation Services Inc. issued guidance (“Prior Guidance”) respecting a Participant’s obligations related to TSX specialty crosses.3 The Prior Guidance respecting basis trading aligned with the TSX rules and provided, among other things that:
- index participation units may be traded as Basis Trades,
- the execution price of a Basis Trade may be outside the prevailing spread at the time of the transaction, and
- details of each Basis Trade must be reported to the Market Regulator on a pre- and post-trade basis.
In 2005, UMIR was amended to add a definition of Basis Order.4 The definition both incorporated the criteria set out in the Prior Guidance into UMIR and provided that a Basis Order may be executed on a marketplace other than the TSX if offered by other marketplaces. The definition defined a Basis Order as:
an order for the purchase or sale of listed securities or quoted securities:
- where the intention to enter the order has been reported by the Participant or Access Person to a Market Regulator prior to the entry of the order;
- that will be executed at a price which is determined in a manner acceptable to a Market Regulator based on the price achieved through the execution on that trading day of one or more transactions in a derivative instrument that is listed on an Exchange or quoted on a QTRS; and
- that comprise at least 80% of the component security weighting of the underlying interest of the derivative instruments subject to the transaction or transactions described in clause (b).
Discussion of the Amendments
The following is a summary of the principal components of the Amendments which are set out in this notice at Appendix A.
Limitation of Definition Prior to Amendments
The UMIR definition of Basis Order prior to the Amendments limits the use of Basis Orders to the purchase and sale of listed securities at a price derived from the prices achieved though the execution or executions of a derivative instrument that is listed on an Exchange or quoted on a QTRS. This definition does not clearly encompass the execution of units of an ETF as a Basis Order at a price derived from the prices achieved through the execution of the component securities.5 This fails to reflect current ETF trading practices and accordingly, IIROC has been granting exemptions for these transactions as IIROC believes that the execution of ETFs as Basis Orders is consistent with the principles supporting Basis Orders generally. During the period of October 1, 2013 to June, 2014, IIROC’s market regulation policy staff granted approximately 30 exemptions.
Exempt Exchange-traded Funds
Exchange-traded funds are regulated by the Canadian Securities Administrators as mutual funds under securities law and not as derivative instruments. As such, references to “derivative instruments” in the UMIR definition of Basis Order could be interpreted to exclude ETFs. Both the TSX definition of Basis Trade and the Prior Guidance provide that an index participation unit may be traded as a Basis Order. IIROC believes that it is appropriate to specifically include ETFs in the definition of Basis Order as the structure of an ETF is similar to that of an index participation unit, as both are designed to track the performance of the underlying component securities. The Amendments incorporate ETFs into the UMIR definition.
Relevance of Underlying Component Securities
IIROC believes that it is appropriate to allow ETFs to be traded as Basis Orders where there is confidence in the relationship between the calculated price for the ETF execution and the actual prices achieved through the execution of the underlying components.
The current UMIR definition of Basis Order requires that at least 80% of the component securities weighting of the derivative instrument traded is comprised of listed securities. Listed securities for the purposes of UMIR are those securities which are listed on an Exchange.6 Accordingly, any derivative instruments where the underlying component securities are not primarily listed securities are excluded from the definition.
In considering the complexity of ETFs currently listed on the Exchanges, IIROC believes it is appropriate to permit Basis Orders in ETF units when the underlying component securities may not be listed securities.
The underlying components of many ETFs do not trade on a marketplace and are therefore not listed securities for the purposes of UMIR. The underlying components of many ETFs trade on foreign markets and may include non-equity products, such as debt, foreign exchange or commodities. In such cases, the execution of the underlying components could not occur on a marketplace.
IIROC acknowledges that pricing on some markets, such as OTC markets, is more opaque than trades that occur on a marketplace which may result in executions with lower confidence that the price achieved represents that actual value of the security. However, given the varying complexities of ETFs currently listed in Canada, IIROC believes it is inappropriate to exclude those ETFs from the definition of Basis Order where the underlying constituents are not principally listed securities.
While the Amendments also provide that a basket of listed securities may be executed at a price derived through the executions of an ETF, IIROC believes that it is appropriate to require that the basket of listed securities is comprised of at least 80% of the component securities weighting of the underlying interest of the ETF. This is consistent with the definition prior to the Amendments in respect to a Basis Order where a basket of listed securities is executed at a price based on the prices achieved through the executions of a derivative instrument that is listed on an Exchange or quoted in a QTRS. The underlying component securities must be comprised of at least 80% listed securities.
In all cases, a Basis Order must be executed at a price which is determined in a manner acceptable to a Market Regulator. When a Basis Order has been used inappropriately, such as when the execution of the underlying component securities represents less than 80% of the securities weighting of the ETF, a Market Integrity Official may require that the trade be printed as a regular trade and that the Participant or Access Person displace any better priced orders. IIROC will also review a Participant’s use of Basis Orders during its trade desk review.
The definition of Basis Order prior to the Amendments requires that the intention to enter the Basis Order must be reported to IIROC prior to the Basis Order being entered on a marketplace. The Amendments do not introduce any additional reporting requirements. The Amendments would clarify that the report to IIROC must be in the form and manner acceptable to IIROC. The reporting requirements applicable to Basis Orders provide IIROC with the opportunity to review and monitor the use of Basis Orders on an ongoing basis. IIROC has modified the Basis Order reporting form to reflect the changes introduced by the Amendments. IIROC expects that a Participant or Access Person would continue its current practice of submitting the Basis Order reporting form after all hedging activity is completed and prior to the entry of the Basis Order.
Changes from the Proposed Amendments
No changes were made to the Proposed Amendments.
Summary of the Impact of the Amendments
Addition of ETFs to the Definition of Basis Orders
The Amendments provide that:
- an ETF may be printed as a Basis Order at a price determined by the actual prices received through the execution of the underlying components where the executions of the underlying component securities represent at least 80% of the ETF, and
- a basket of listed securities that comprise at least 80% of the component securities weighting of an ETF may be printed as a Basis Order at a price determined by the actual prices received though the execution of an ETF on a marketplace.
Component Securities of an ETF Expanded to Include Securities Other Than Listed Securities
The Amendments provide for the execution of a Basis Order involving units of an ETF where the underlying component securities are:
- not listed securities, or
- a combination of both listed securities and securities that are not listed securities.
Technological Impacts and Implementation Plan
IIROC does not expect the Amendments to cause any technological impact to the Dealer Member. The only technological impact is the development effort required by IIROC to amend the Basis Order Reporting Form to accommodate the changes introduced by the Amendments. The Amendments have been approved by the applicable securities regulatory authorities as of the date of this Rules Notice. The Amendments become effective immediately.
Appendix A – UMIR Amendments
Appendix B – Comments Received in Response to Rules Notice 14-0077 – Rules Notice – Request for Comments – UMIR– Proposed Amendments to the Definition of Basis Order (March 27, 2014)
- 3See MIN 2003-023 – Obligations related to TSX Specialty Crosses – October 28, 2003.
- 4See Market Integrity Notice 2005-010 – Provisions Respecting a “Basis Order” – April 8, 2005.
- 5ETFs are regulated as mutual funds under securities law and not as derivative instruments.
- 6Exchange is defined in UMIR to mean a person recognized by the applicable securities regulatory authority under securities legislation to carry on business as an exchange.