Purpose of the Study

Securities regulators in Canada and abroad have recently taken regulatory action to protect investors and market integrity in light of the current and unprecedented market turmoil. To address concerns of investors and marketplace participants, the Investment Industry Regulatory Organization of Canada (“IIROC”) increased its regular monitoring of trading on equity marketplaces in Canada, including heightened surveillance of all short selling activity and rates of trade failure.

As part of the monitoring, IIROC has undertaken a study (“the “Short Prohibition Study”) to evaluate the impact of the orders of the Ontario Securities Commission (“Orders”) prohibiting short sales between September 22, 2008 and October 8, 2008 of certain financial sector issuers listed on the Toronto Stock Exchange (“TSX”) that were also listed on an exchange in the United States (“Restricted Financials”).1 The analysis covered the period August 1, 2008 to October 24, 20082 and compared the trading activity on Canadian marketplaces of Restricted Financials with certain other issuers in the financial sector that were listed only on the TSX (“Non-Restricted Financials”).

Summary

The Short Prohibition Study found that:

• while there were “unusual” levels of trading activity in financial sector issuers immediately preceding the issuance of the Orders:
  • short sales of Restricted Financials were in line with, or less than, historic patterns and the levels of short selling for inter-listed securities generally,
  • there was no evidence of undue short selling pressure in Non-Restricted Financials, and
  • the short position in the Restricted Financials was declining and accounted for a lower percentage of the issued capital than for TSX-listed securities generally; and
• the issuance of the Orders:
  • was coincidental with significant and proportional increases in volatility for each of Restricted Financials, Non-Restricted Financials and securities generally, and
  • appeared to have a significant impact on market quality for trading of Restricted Financials by reducing available liquidity and increasing the price “spread”.

A copy of the Short Prohibition Study is available on the IIROC website (www.iiroc.ca) under the heading “News Room” and the sub-heading “Publications”.

The purpose of this information is intended to assist in focusing discussions on whether initiatives regarding short sales that have been introduced or may be considered by securities regulators in foreign jurisdictions would be appropriate in the context of the Canadian market.

Findings

In summary, during the Study Period:

• the issuance of the Orders did not appear to have had any appreciable effect on the price of securities of either Restricted Financials or Non-Restricted Financial (both of which have performed better than benchmark index of market performance);3
• there were “unusual” levels of activity in “financial sector” securities (both the Restricted and Non-Restricted Financials) in the Pre-Order Week;4
• the proportion of short sales of Restricted Financials in the Pre-Order Period was in line with, or less than, historic patterns and the levels of short selling for inter-listed securities generally;5
• there was no evidence of undue short selling pressure in the Non-Restricted Financials In the Pre-Order Period (including the Pre-Order Week);6
• the issuance of the Orders appeared to have had a significant impact on market quality for the trading of the Restricted Financials by:
  • reducing liquidity available in the Restricted Financials,7 and
  • increasing the “spread” for Restricted Financials as measured by the difference between the closing bid and ask prices;8
• the issuance of the Orders did not appear to have had an impact of the relative levels of the intra-day and inter-day price volatility between the Restricted Financials and Non- Restricted Financials, though overall levels of volatility increased coincidental with the issuance of the Orders and the actions by the Securities and Exchange Commission in the United States;9 and

• prior to the issuance of the Orders, the short position in the Restricted Financials was declining and the short position in Restricted Financials as a percentage of the issued capital was less than for TSX-listed securities generally.10

• 1IIROC has issued a study that sets out certain information with respect to recent trends in trading activity and, in particular, short selling and failed trades in the period May 1, 2007 to September 30, 2008. Reference should be made to IIROC Notice 09-0037 - Administrative Notice – General – Recent trends in Trading Activity, Short Sales and Failed Trades (February 4, 2009). That study does not attempt to specifically evaluate the impact of the Orders, though a number of the effects on the general trends of the prohibition on short selling are noted throughout that study.
• 2For the purposes of the analysis, the Study Period was sub-divided into four periods:
  • Pre-Order Period – being August 1, 2008 to September 19, 2008;
  • Pre-Order Week – being September 15, 2008 to September 19, 2008;
  • Order Period – being September 22, 2008 to October 8; 2008; and
  • Post-Order Period – being October 9, 2008 to October 24, 2008.
• 3During the Order Period, the closing price of Restricted Financials averaged 99.1% of the levels at the start of the Study Period as compared to 95% for the Non-Restricted Financials and 84.9% for the S&P/TSX Composite Index.
• 4During the Study Period, Restricted Financials accounted for 9.5% and Non-Restricted Financials accounted for 2.75% of trading in TSX- listed securities. During the Pre-Order Week, trading activity in Restricted Financials accounted for 13.8% (approximately 45% above the Study Period average) and Non-Restricted Financials account for 3.33% (approximately 21% above the Study Period average) of trading in TSX-listed securities.
• 5During the Pre-Order Period, short sales constituted 30.8% of trades in Restricted Financials and 28.4% during the Pre-Order Week. In the period May 1, 2007 to September 30, 2008, short sales of inter-listed securities averaged 30.3% of trades.
• 6During the Pre-Order Period, short sales accounted for 25.3% of trades and 23.1% of volume in Non-Restricted Financials with 25.2% of trades and 21.9% of volume during the Pre-Order Week. During the period May 1, 2007 to September 30, 2008, short sales accounted for 19.3% of trades in TSX-listed securities other than inter-listed securities and Exchange-traded Funds.
• 7From the Pre-Order Period to the Order Period, the average number of trades in securities of Restricted Financials declined 14% (declining from an average of 73,333 trades per day to 63,097) while the average number of trades in TSX-listed securities other than Restricted Financials increased approximately 34% (from an average of 641,339 trades per day to 858,835). From the Pre-Order Period to the Order Period, the average daily volume in Restricted Financials increased 15% (increasing from an average volume of 24,699,179 shares per day to 28,404,578 shares per day) while the average volume in TSX-listed securities other than Restricted Financials increased by approximately 27% (from an average volume of 395,934,451 shares per day to 501,907,110 shares per day.
• 8During the Pre-Order Period, the average closing bid/ask spread for Restricted Financials was 0.13% of the closing bid as compared to 0.29% for Non-Restricted Financials. During the Order Period, the average closing bid/ask spread for Restricted Financials had more than tripled to 0.40% of the closing bid as compared to 0.44% for Non-Restricted Financials.
• 9During the Pre-Order Period, the average difference between the daily high and low prices for Restricted Financials was 3.43% of the daily low price as compared to 3.30% for Non-Restricted Financials. During the Order Period, average difference between the daily high and low prices for Restricted Financials was 6.16% of the daily low price as compared to 5.66% for Non-Restricted Financials. The intra-day volatility in the Order Period increased 80% for Restricted Financials and approximately 72% for Non-Restricted Financials from the levels of intra-day volatility in the Pre-Order Period. During the Pre-Order Period, the average difference between the closing price on a trading day and the closing price on the immediately preceding trading day for Restricted Financials was 2.48% of the closing price as compared to 2.58% for Non-Restricted Financials. During the Order Period, average difference between the closing price on a trading day and the closing price on the immediately preceding trading day for Restricted Financials was 4.40% of the closing price as compared to 3.90% for Non-Restricted Financials. The inter-day volatility in the Order Period increased 77% for Restricted Financials and approximately 51% for Non-Restricted Financials from the levels of inter-day volatility in the Pre-Order Period.
• 10From August 31, 2008 to September 15, 2008, the aggregate short position in Restricted Financials declined 5.4%. The proportion that the short positions represented of the outstanding shares of the Restricted Financials declined from 0.872% of issued capital to 0.825%. The proportion that short positions represented of the outstanding shares of all TSX-listed securities declined from 0.956% to 0.918%.