1. Development of Proposals for the Canadian Market

1. Joint CSA/IIROC Consultation Paper

The publication of this IIROC Notice is the last step in a process that began in late 2009.  In the Joint CSA/IIROC Consultation Paper 23-404 Dark Pools, Dark Orders, and Other Developments in Market Structure in Canada4 (“Consultation Paper”), comment was sought on a number of issues, particularly the general impact of marketplaces that offer no pre-trade transparency on any orders (“Dark Pools”), the introduction of dark order types, and the introduction of smart order routers.  The Consultation Paper discussed these issues and their potential impact on the Canadian markets, including their impact on market liquidity, transparency, price discovery, fairness and integrity.5

1. Dark Liquidity Forum

On March 23, 2010, the CSA and IIROC hosted a forum to discuss the issues raised in the Consultation Paper and in the response letters (“Forum”).  The themes discussed at the Forum included:

• whether Dark Pools should be required to provide price improvement and if so, what is meaningful price improvement;
• the use of market pegged orders and whether those orders “free-ride” off the visible market;
• the use of sub-penny pricing;
• broker preferencing at the marketplace level and dealer internalization of order flow;
• the use of Indications of Interest (IOIs) by Dark Pools to attract order flow; and
• the fairness of a marketplace offering smart order router services that use marketplace data that is not available to other marketplace participants.

More details regarding the Forum were included in Joint CSA/IIROC Staff Notice 23-308 Update on Forum to Discuss CSA/IIROC Joint Consultation Paper 23-404 “Dark Pools, Dark Orders and Other Developments in Market Structure in Canada” and Next Steps published on May 28, 2010 (“Update”).  That notice included a discussion of ongoing initiatives, proposed next steps to address some of the issues, and a summary of the comments received in response to the Consultation Paper.

1. Joint CSA/IIROC Position Paper

On November 19, 2010, the CSA and IIROC published a joint position paper (“Position Paper”)6  that set out CSA and IIROC’s position on the following questions:

• Under what circumstances should Dark Pools or marketplaces that offer dark orders be exempted from the requirements of pre-trade transparency under NI 21-101?
• Should Dark Orders be required to provide meaningful price improvement over the best bid price or the best ask price (“NBBO”), and under what circumstances?
• Should visible (lit) orders have priority over dark orders at the same price on the same marketplace?
• What is a “meaningful” level of price improvement?

The recommendations in the Position Paper regarding these four issues were as follows:

• The only exemption to pre-trade transparency should be for orders that meet a minimum size threshold.
• Two dark orders meeting the minimum size threshold should be able to execute at the NBBO.  Meaningful price improvement should be required in all other circumstances, including all executions with orders not specifically marked in a manner indicating they are using the minimum size exemption.
• Visible orders on a marketplace should execute before dark orders at the same price on the same marketplace. However, an exception could be made where two dark orders meeting the minimum size threshold can be executed at that price.
• Meaningful price improvement means that the price is improved over the NBBO by a minimum of one trading increment as defined in the UMIR, except where the NBBO spread is already at the minimum tick. In this case, meaningful price improvement would be at the mid-point of the spread.

1. Joint CSA/IIROC Regulatory Approach to Dark Liquidity in Canada

On July 29, 2011, concurrent with the publication of the Proposed Amendments, IIROC and the CSA published a joint notice on the regulatory approach to dark liquidity in Canada (“Joint Notice”).7   Reference should be made to the Joint Notice for a more detailed outline of the policy considerations underlying the Amendments.  The Joint Notice also contains a discussion of:

• the final report of the Technical Committee of the International Organization of Securities Commissions (“IOSCO”) entitled “Principles on Dark Liquidity”, which contains principles to assist securities markets authorities in dealing with issues concerning dark liquidity; and
• other relevant current international initiatives, particularly proposals from the Australian Securities and Investments Commission, the European Securities and Markets Authority and the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues.

1. Related IIROC and CSA Initiatives 

The comments which IIROC received on the Proposed Amendments are summarized in Appendix B of this Notice.  Following the comment period, IIROC reviewed with stakeholders that made submissions on the Proposed Amendments their comments that:

• dark liquidity does not pose a threat to the price discovery mechanism;
• regulators should focus on “more important issues”, with the one most often mentioned being the effects of high frequency trading;
• orders, particularly those of “uninformed investors” or those initiated without the benefit of sophisticated technology, will face possible manipulation on displayed markets;
• active order fees will increase dealer costs;8 and
• dealers will direct order flow to the United States to maintain favourable trading costs.9

IIROC acknowledges that the Amendments will not address a number of these concerns, particularly as some of the concerns are beyond the jurisdiction of IIROC.  Therefore, in order to address:

• questions related to the impact of dark liquidity on the operation of the price discovery mechanism, IIROC proposes to continue to monitor trading trends with particular attention on bid-ask spreads;10
• concerns about new forms of “high tech” manipulations, IIROC will be issuing additional guidance on activities that may constitute manipulative and deceptive trading and introducing new surveillance alerts to monitor for such activities;
• other issues surrounding high frequency trading, IIROC will be:
  • completing and publishing the results of a study of high frequency trading and the impact of such activity on market quality in both transparent markets and Dark Pools, and
  • monitoring the impact of the new IIROC Regulation Fee model (which will recover the technology portion of the IIROC’s costs based on message traffic) particularly on variations in order-to-trade ratios and strategies for trading on displayed marketplaces;
• possible impacts on trading costs, IIROC and the CSA continue to discuss next steps to examine this issue, though it should be noted that the CSA is presently undertaking a study of market data fees; and
• concerns that order flow may be directed away from the Canadian market, IIROC is proposing a separate anti-avoidance clarification of the Order Exposure Rule which would preclude the execution of certain orders on a foreign organized regulated market without either display or the execution of the order at a “better price”.11

IIROC and the CSA acknowledge that the implementation of the Amendments will have an impact on existing trading activities in Canada and on the development of marketplaces, order types and features available in the Canadian market.  For this reason, IIROC and the CSA will be monitoring the impact of the Amendments, which will help to determine whether a minimum size for Dark Orders is required or preferable and whether any adjustments may need to be made to the requirements of the Amendments.

1. Discussion of the Amendments

1. Definition of “Better Price”

Until the Amendments come into force on October 10, 2012, UMIR defines a “better price” simply as a lower price than the best ask price in the case of a purchase and a higher price than the best bid price in the case of a sale.  The term “better price” is redefined by the Amendments to require at least one trading increment price improvement except when the difference between the best bid price and the best ask price is a single trading increment in which case a half-increment would be accepted.  The revised definition sets the minimum amount of price improvement that would be acceptable for a “small” order (being 50 standard trading units or less which is 5,000 units of a security trading at $1.00 or more per unit, 25,000 units of a security trading at $0.10 or more per unit and less than $1.00 and 50,000 units when a security is trading at less than $0.10 per unit) when it executes with a Dark Order.

The revised definition is also applicable to the requirements under the Order Exposure Rule (Rule 6.3 which permits small orders to be withheld from an immediate entry on a marketplace if executed at a “better price”) and the Client-Principal Trading Rule (Rule 8.1 which requires that principal trades with small client orders be undertaken at a “better price” in order to avoid conflicts) and the Amendments provide greater certainty in the application of those rules.  The revised definition makes clear that a “better price” applies in respect of each trade resulting from an order.  For example, a “better price” would not be achieved if an order to purchase or sell 1,000 shares of a security executed in two trades with 100 shares receiving a $0.01 price improvement and the balance of 900 shares executing at the NBBO.  In order to be considered a “better price”, all 1,000 shares must be executed with a minimum price improvement of a trading increment (or one-half of an increment if the NBBO spread is only a single trading increment).

1. Definition of “Dark Order”

The Amendments introduce a definition of Dark Order for use in a number of substantive UMIR provisions dealing with:

• the size of Dark Orders;
• priority of execution; and
• price improvement requirements.

However, the term Dark Order has been defined in such a manner that a separate regulatory order marker is not required.  Instead, order types and functionality established by each marketplace would determine whether or not a particular order entered on that marketplace would be considered to be a Dark Order.  An order for which no portion is displayed at the time of entry on a marketplace in a consolidated market display would be a Dark Order but any order which is immediately executed on entry or which is a “specialty” type of order that may execute at a price outside of the best bid price/best ask price spread would be excluded from the definition of Dark Order.

Under the Amendments, a “Dark Order” means:

1. an order no portion of which is displayed on entry on a marketplace in a consolidated market display; or
2. that portion of an order which on entry to a marketplace is not displayed in a consolidated market display if that portion may trade at a price other than the price displayed by that portion of the order included in the consolidated market display

but does not include an order entered on a marketplace as:

3. part of an intentional cross;
4. a market order that is immediately executed in full on one or more marketplaces at the time of entry;
5. a limit order that is immediately executed in full on one or more marketplaces at the time of entry;
6. a Basis Order;
7. a Call Market Order if that Call Market Order may only trade with other Call Market Orders and the matching of Call Market Orders occurs less frequently than once every minute;
8. a Closing Price Order;
9. a Market-on-Close Order;
10. an Opening Order; or
11. a Volume-Weighted Average Price Order.

It is important to note that a Call Market Order may be considered to be a Dark Order.  Generally, a small order that executes with a Call Market Order would have to receive “price improvement” in the form of an execution at a “better price”.  It is also important to note that an iceberg order (a portion of which is displayed in a consolidated market display) will not be considered a Dark Order and, as such, the hidden portion of the order would not have to provide “price improvement” on execution.  However, if the hidden portion of the order could trade at a price other than the price displayed by the visible portion, the hidden portion of the order will be a Dark Order.

1. Clarification of Requirements of the Order Exposure Rule

The Amendments make a clarification to the Order Exposure Rule.  Since “transparent” marketplaces may introduce Dark Orders, the requirements under the Order Exposure Rule are amended to ensure that any order required to be entered on a transparent marketplace is “for display” in a consolidated market display.  Under the Amendments, a “small” client order could not be entered on a transparent marketplace as a Dark Order except with the express instruction or consent of the client.

1. Size Requirements for Dark Orders and Icebergs

The CSA has amended National Instrument 21-101 to permit a regulation services provider to designate the minimum size of a Dark Order.12  The Amendments add Rule 6.5 to UMIR and provide IIROC with the specific power to make such a designation.  In order to avoid potential gaming of this provision and the requirement for Dark Orders to provide price improvement in certain circumstances, Rule 6.5 also provides that an iceberg order must display at least one standard trading unit or such greater size as designated by IIROC. 

In the event that IIROC proposes at some future time to designate, or to change any designation of, a number of units of a security for the purposes of Rule 6.5, IIROC will consult with the applicable securities regulatory authorities and will issue a notice requesting public comment during a comment period of at least 30 days.  Following the comment period and upon the approval of the designation or change by the applicable securities regulatory authorities, IIROC will issue a notice of the number of units of a security that have been designated for the purposes of clause (a) or (b) of Rule 6.5 and the effective date of the designation which would allow for an appropriate notice period. 

IIROC will ensure that there will be full public consultation prior to the initial establishment of any size requirements.  As noted in section 1.5 of this Notice (Related IIROC and CSA Initiatives), IIROC and the CSA will be conducting an analysis of the impact of the Amendments.  The results of this analysis will inform the deliberations on any future proposed designation of minimum sizes for Dark Orders.  IIROC would expect to publish the results of the analysis as part of any initiative to designate any minimum size for Dark Orders or to propose any revisions to the Amendments or any other provisions of UMIR specifically related to dark liquidity.

Unless and until IIROC designates a minimum size, a Dark Order may be any size.  However, the effect of the Order Exposure Rule means a client order to purchase or sell 50 standard trading units or less of a security that is not immediately executed at a better price or otherwise exempted from the requirements of the Order Exposure Rule13 may only be entered on a marketplace as a Dark Order with the express instruction or consent of the client.  In addition, Dark Orders for 50 standard trading units or less may be entered on a marketplace by or for:

• a principal account;
• a non-client account;
• an Access Person (essentially a subscriber to an alternative trading system that is not a dealer);
• a client account if the order entered as a Dark Order is part of a larger client order for the particular security which, when provided to the Participant, was for more than 50 standard trading units.

1. Price Improvement by a Dark Order

Under the Amendments, any order which trades with a Dark Order would have to receive price improvement on the execution unless the order, as entered on the marketplace, is for more than 50 standard trading units or has a value of more than $100,000.  If the order meets either of these requirements, the order could trade with the Dark Order at the market price, provided no displayed orders are available on that marketplace at the market price.14 If the order as entered on the marketplace exceeds the size parameters, any portion of the order which does not execute with visible orders on that marketplace may execute with a Dark Order provided that are no visible orders on that marketplace at that price and there are no visible orders at a “better price” on another marketplace.  This provision provides execution priority to visible orders on a marketplace at the same price as Dark Orders on that marketplace.  Under the Amendments, a “large” order entered on a marketplace will be able to execute with a Dark Order at a particular price even though visible orders may be displayed on other marketplaces at that price. 

There are a number of additional exceptions if the order that trades with the Dark Order is one of the “specialty” orders that can otherwise trade outside of the best bid – best ask spread (being:  a Basis Order; a Call Market Order; a Closing Price Order; a Market-on-Close Order; an Opening Order or a Volume-Weighted Average Price Order).

The hidden portion of an “iceberg” order is not considered to be a Dark Order as at least one standard trading unit of the iceberg order must be displayed in a consolidated market display and thereby contribute directly to the price discovery mechanism by being eligible to establish the best ask price or the best bid price for the purposes of UMIR.  For this reason, the hidden portion of an iceberg order is not required to provide price improvement.

1. Inability to Rely on Marketplace Functionality

The Amendments add a new provision to UMIR which prohibits a Participant or Access Person from relying on marketplace functionality that they know will result in an order or trade failing to comply with UMIR.  A Participant or Access Person will have breached UMIR if they enter an order on a marketplace and know or ought reasonably to have known that the functionality of that marketplace would permit the order to execute with a Dark Order without receiving price improvement if required by UMIR or without providing priority to visible orders on that marketplace on the same side of the market.  This provision is consistent with current guidance that IIROC has issued (in particular in connection with “locked” and “crossed” markets15 ) regarding the obligation of the Participant or Access Person when entering orders on a particular marketplace.

IIROC acknowledges that marketplaces presently offer functionality and orders types that would not guarantee sufficient price improvement to constitute a “better price” for the purposes of the proposed amendments.  As of October 10, 2012, the effective date of the Amendments, each marketplace will have to ensure that its system functionality and order types comply with the applicable requirements in the Amendments; otherwise Participants and Access Persons would be precluded from using such functionality or order types.  (See “Technological Implications and Implementation Plan” on page 15.)

1. Execution Price of Orders

With the change to the definition of “better price” under the Amendments, UMIR will specifically acknowledge that trades may execute at a fraction of a trading increment.  Marketplaces will be able to introduce order types or functionality that allows for the execution of orders at a “better price”.  For example, when the NBBO spread is at one trading increment, executions could occur at the mid-point.  If the spread is more than one trading increment execution could occur at the mid-point or at another price level that would provide price improvement for both sides of the trade.

For this reason, the Amendments revise the provisions regarding the reporting of the trade price to allow any trade (and not just the trade price of a Basis Order, Call Market Order or a Volume-Weighted Average Price Order as contemplated by the current policy under Policy 6.1) to be reported at the execution price provided that, if required by the information processor or information vendor, the reported trade price shall be rounded to the nearest trading increment16 .

1. Better-Priced Intentional Cross

Rule 6.1 of UMIR requires that orders entered on a marketplace be at a price which is a full cent unless the price of the order is less than $0.50 when the price may be one-half of one cent.  Since the Amendments will permit executions at fractional trading increments, they introduce the exception to the “full trading increment” rule for an order entered as an intentional cross at a better price.  Intentional crosses may be entered on a marketplace at a price which is a fraction of a trading increment provided the execution price is a better price for both the order to purchase and the order to sell.  For example, if the spread between the best bid price and the best ask price for a security trading above $0.50 is $0.03, an intentional cross could be completed at the mid-point or at any other price permitted by the marketplace that is at least $0.01 above the best bid price and $0.01 below the best ask price.

1. Changes from the Proposed Amendments

Based on comments received from the public and the CSA, and the repeal of the tick test for short sales effective September 1, 2012,17 the Amendments as approved vary from the Proposed Amendments in a number of areas including:

• clarifications to the proposed definition of Dark Order to include:
  • the non-disclosed portion of an iceberg order that is “pegged” and can trade at a different price than the disclosed portion,
  • a market order that does not fully execute on entry, and
  • a Call Market Order that is matched more often than once every minute;
• permitting reported trade prices and the “last sale price” to be a fraction of a trading increment;
• permitting the entry of an intentional cross at a fractional trading increment that is a better price to facilitate compliance with the requirements of the Order Exposure Rule and the Client-Principal Trading Rule;
• amending the Order Exposure Rule to clarify that an order which is withheld from entry for display “based on market conditions” cannot be entered as a Dark Order; and
• clarifying that a Dark Order when executing at the bid or the ask does not owe an obligation to any order on that marketplace that is not used to determine the best bid price or best ask price (e.g. odd lot- or Special Terms Orders).

1. Summary of the Impact of the Amendments

The most significant impacts of the adoption of the Amendments are to:

• ensure that visible orders on a marketplace are given execution priority over Dark Orders on that marketplace at the same price;
• require Dark Orders to provide a better price, except when executing with “large” orders; and
• provide that a better price is at least one trading increment and, when the displayed market has a spread of only one trading increment, at least one-half of a trading increment.

1. Technological Implications and Implementation Plan

The technological implications of the Amendments on Participants, Access Persons, marketplaces or service providers are as follows:

• there will be no impact on the systems of transparent marketplaces that do not provide for Dark Orders nor iceberg orders with less than one standard trading unit being displayed;
• since the Amendments do not require the marking of Dark Orders, there will be no impact on the systems of Participants, Access Persons or service providers; and
• Dark Pools and transparent marketplaces that permit Dark Orders or icebergs with less than one standard trading unit being displayed will be required to ensure that their trading system functionality provides:

• execution priority for visible orders on their marketplace over Dark Orders on their marketplace at the same price, and
• a better price to orders (other than “large” orders) that execute with Dark Orders.

The Amendments have been approved by the Recognizing Regulators as of the date of this Rules Notice.  However, implementation of the Amendments has been deferred and they will become effective on October 10, 2012, being one hundred and eighty (180) days following the date of this Rules Notice.

Appendices

Press release – CSA and IIROC announce the implementation of a dark liquidity framework in Canada

Appendix A – Text of Provisions Respecting Dark Liquidity

Appendix B – Comments Received in Response to Rules Notice 11-0225 - Request for Comments -UMIR - Provisions Respecting Dark Liquidity

• 4Published at (2009) 32 OSCB, beginning at page 7877.
• 5See the Consultation Paper at page 7880.
• 6IIROC Notice 10-0303 – Rules Notice – Request for Comments - UMIR – Joint Canadian Securities Administrators/Investment Industry Regulatory Organization of Canada – Position Paper 23-405 - Dark Liquidity in the Canadian Marketplace (November 19, 2010).
• 7IIROC Notice 11-0226- Rules Notice – Request for Comments – UMIR – Joint Canadian Securities Administrators/Investment Industry Regulatory Organization of Canada  Staff Notice 23-311 – Regulatory Approach to Dark Liquidity in the Canadian Market (July 29, 2011).  Appendix “A” to that notice contained a summary of the 20 comments received on the Position Paper and the responses of the CSA and IIROC.
• 8Certain of the commentators believe that the Amendments will result in less liquidity being provided in Dark Pools or through Dark Orders. As a result, dealers would be required to send active orders to transparent markets that may charge higher fees for accessing liquidity thereby increasing trading costs to dealers.
• 9Certain of the commentators stated that the Amendments would provide an incentive for dealers to “sell” their order flow to “wholesalers” in the U.S.
• 10In the Joint Notice, IIROC and the CSA acknowledged that the historic levels of dark liquidity in Canada have not had a negative impact on the operation of the price discovery mechanism. See also footnote 13.
• 11See IIROC Notice 12-0131 - Rules Notice – Request for Comments – UMIR – Provisions Respecting the Execution and Reporting of Certain “Off-Marketplace” Trades (April 13, 2012).
• 12Canadian Securities Administrators Notice of Amendments to National Instrument 21-101 Marketplace Operation and Companion Policy 21-101 CP and to National Instrument 23-101 Trading Rules and Companion Policy 23-101 CP (2012) 35 OSCB (Supp-1) (March 23, 2012).
  
  In discussing the policy rationale for this proposed amendment to subsection 7.1(2) of NI 21-101, the CSA stated:
  
  We acknowledge that, to date, there has been limited activity in dark pools and no evidence that dark liquidity has had a negative impact on the Canadian capital markets. However, we are of the view that it is important and timely to establish a regulatory framework so that we are in a position to respond expeditiously to future market developments. For this reason, in the proposed amendments to NI 21-101, we propose to introduce a requirement that orders meet a minimum size established by a regulation services provider in order to be exempt from the transparency requirements in NI 21-101. However, at this time no minimum order size is being proposed. Any size threshold that may be proposed in the future would be set in consultation with the CSA and would follow the regular public comment process. The CSA and IIROC will continue to monitor the level of activity on non-transparent marketplaces and its impact on price discovery to determine whether and when to propose a specific size threshold.
  
  See Canadian Securities Administrators Notice of Proposed Amendments to National Instrument 21-101 Marketplace Operation and National Instrument 23-101 Trading Rules (2011) 34 OSCB (Supp-1) (March 18, 2011).
• 13Rule 6.3 - Exposure of Client Orders requires that an order for 50 trading units or less must be immediately entered on a transparent marketplace unless otherwise exempted. Permitted exemptions include:
  (a) if the client has specified different instructions;
  (b) if the order is executed immediately at a better price;
  (c) if the order is returned for the terms of the order to be confirmed;
  (d) if the order is withheld pending confirmation that the order complies with applicable securities requirements;
  (e) if entering the order based on market conditions would not be in the interests of the client;
  (f) if the order has a value greater than $100,000;
  (g) if the order is part of a trade to be made in accordance with Rule 6.4 by means other than entry on a marketplace; or
  (h) if the client has directed or consented that the order be entered on a marketplace as a Call Market Order, an Opening Order, a Special Terms Order, a Volume-Weighted Average Price Order, a Market-on-Close Order, a Basis Order, or a Closing Price Order.
  IIROC has proposed an amendment to clause (g) of Rule 6.3 which is intended to be an anti-avoidance provision to ensure that an execution on a foreign organized regulated market is not undertaken to avoid the application of the Order Exposure Rule or the Amendments.  See IIROC Notice 12-00** - Rules Notice – Request for Comments – UMIR – Provisions Respecting the Execution and Reporting of Certain “Off-Marketplace” Trades (April 13, 2012).  In particular, clause (g) of Rule 6.3 would be amended to read as follows:
  (g) the order is part of a trade to be made in accordance with Rule 6.4 by means other than entry on a marketplace provided, if the order was executed on a foreign organized regulated market, the order was: (i) entered on a market which publicly displays and provides timely information on orders and the order executed on entry or was displayed, or (ii) executed at a better price.
   
• 14Upon the Amendments becoming effective, previous guidance issued by IIROC to the effect that an order “routed to a non-transparent marketplace or facility to determine if liquidity is available on that marketplace or facility at prices that are the same or better than displayed in a consolidated market display would comply with the requirements of Rule 6.3” will be repealed since such order would not be able to execute at the “same” price displayed in a consolidated market display. See the response to question 1 under Market Integrity Notice 2007-019 – Guidance – Entering Client Orders on Non-Transparent Marketplaces and Facilities (September 21, 2007).
• 15In particular, see the response to question 8 in IIROC Notice 11-0043 - Rules Notice – Guidance Note – UMIR – Guidance on “Locked” and “Crossed” Markets (February 1, 2011).
• 16If the trade executed at one-half of a trading increment, the price shall be rounded up to the next trading increment.
• 17The “tick test” under Rule 3.1 of UMIR has been repealed effective September 1, 2012. See IIROC Notice 12-0078 – Rule Notice – Notice of Approval – UMIR – Provisions Respecting the Regulation of Short Sales and Failed Trades (March 2, 2012).