1. Background to the Amendments

1. Electronic Trading Rule

1. Framework for Regulation of Electronic Trading

The ETR introduces a comprehensive framework designed to address areas of concern and risks brought about by electronic trading.  Generally, the ETR places responsibility for managing risks and maintaining supervisory controls, policies and procedures related to electronic trading on:

• a “marketplace participant” (defined as:  a member of an exchange; user of a Quotation and Trade Reporting System; or subscriber of an ATS) whether trading is of a proprietary nature or on behalf of clients; and
• a marketplace.

1. Requirements Applicable to Marketplace Participants

The ETR builds on the obligations outlined in Section 11.1 of National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations8  (“NI 31-103”) under which  a registered firm must establish, maintain and apply policies and procedures that establish a system of controls and supervision sufficient to provide reasonable assurance that the firm and each individual acting on its behalf complies with securities legislation and   manage the risks associated with its business in accordance with prudent business practices.

The ETR requires that these risk management and supervisory controls, policies and procedures must be reasonably designed to:

• ensure that all orders are monitored pre- and post-trade;
• systematically limit the financial exposure of the marketplace participant;
• ensure compliance with all marketplace and regulatory requirements;
• ensure the marketplace participant can stop or cancel the entry of orders to a marketplace;
• ensure the marketplace participant can suspend or terminate any marketplace access granted to a client; and
• ensure the entry of orders does not interfere with fair and orderly markets.

A participant dealer9 may on a reasonable basis, authorize an investment dealer to perform on its behalf the setting or adjustment of a specific risk management or supervisory control, policy or procedure under certain circumstances where the investment dealer’s relationship with an ultimate client would provide them with better access to information, and would thus provide for a more effective setting or adjusting of the control, policy or procedure.  Granting such an authorization would require a written agreement between the participant dealer and the investment dealer, and a regular and ongoing assessment of the adequacy and effectiveness of such an agreement.

1. Requirements Applicable to Use of Automated Order Systems

The ETR establishes requirements surrounding the use of automated order systems.10   A marketplace participant is required to take all reasonable steps to ensure that any use of an automated order system either by itself or by any client does not interfere with fair and orderly markets.  Similarly, any client of a marketplace participant is itself obligated to take reasonable steps to ensure the same.

A marketplace participant must also have a level of knowledge and understanding of any automated order system used by itself or a client that is sufficient to identify and manage any risks associated with its use.  A marketplace participant must also ensure that each automated order system is tested prior to use, and at least annually thereafter, and have controls in place to immediately disable and prevent orders generated by an automated order system from reaching a marketplace.

1. Requirements Applicable to Marketplaces

In addition to marketplace participants, the ETR also recognizes the role of the marketplace in managing the risks associated with electronic trading.  The ETR places a requirement on a marketplace to prevent the execution of orders from exceeding price and/or volume thresholds set by the regulation services provider or by a marketplace if it is a recognized exchange or quotation and trade reporting system that directly monitors the conduct of its members or users and enforces certain requirements set pursuant to the CSA Trading Rules.11  

The ETR also sets outs specific conditions under which a marketplace may cancel, vary or correct a trade executed on that marketplace.  The marketplace must establish, maintain and ensure compliance with reasonable policies and procedures that clearly outline how a variation, cancellation or correction can occur, and must make these policies and procedures publicly available.

Additionally, the ETR requires a marketplace to provide a marketplace participant with access to its order and trade information on an immediate basis and on reasonable terms, to ensure that marketplace participants can effectively implement the risk management and supervisory controls policies and procedures required by the rule.

1. Pre-existing Supervision Obligations for Electronic Trading under UMIR

Currently, Rule 7.1 of UMIR establishes trading supervision obligations which Participants must follow, including:

• adopting written policies and procedures to be followed by directors, officers, partners and employees of the Participant that are adequate, taking into account the business and affairs of the Participant, to ensure compliance with UMIR and each Policy; and
• complying, prior to the entry of an order on a marketplace, with:
  • applicable regulatory standards with respect to the review, acceptance and approval of orders,
  • the policies and procedures adopted, and
  • all requirements of UMIR and each Policy.

Policy 7.1 of UMIR elaborates further on the responsibility of Participants for trading supervision and compliance, and certain elements of Policy 7.1 relate more particularly to electronic trading.  Specifically, the obligation to supervise applies whether the order is entered on a marketplace:

• by a trader employed by the Participant;
• by an employee of the Participant through an order routing system;
• directly by a client and routed to a marketplace through the trading system of the Participant; or
• by any other means.

The Participant maintains responsibility for any order which is entered on a marketplace without the involvement of a trader employed by the Participant, as an example when the client maintains a “systems interconnect arrangement” in accordance with marketplace requirements.  In such circumstances adequate supervision policies and procedures are required to address the potential additional risk exposure with orders not directly handled by the Participant but that remain the Participant’s responsibility. 

1. Discussion of the Amendments

The following is a summary of the principal components of the Amendments which are set out in Appendix A of this notice:

1. Trading Supervision Obligations

1. Risk Management and Supervisory Controls, Policies and Procedures

Rule 7.1 currently establishes trading supervision obligations which Participants must follow, including the establishment of written policies and procedures to ensure compliance with UMIR.  With the ETR providing a new framework designed to mitigate the risks of electronic trading, the Amendments add several new subsections to align the supervisory requirements of Rule 7.1 with the requirements of the ETR.

The Amendments would require that a Participant or Access Person adopt a system of risk management controls designed to ensure the management of risks specifically associated with electronic trading.  Particularly, they should be designed to manage the risks associated with access to one or more marketplaces, and if applicable, the use of any automated order system, by a Participant, a client of the Participant or an Access Person.

Part 7 of Policy 7.1 provides further information regarding the requirements set out in Rule 7.1, and details the expectations in regard to the elements of the risk management and supervisory controls, policies and procedures which must be employed by Participants and Access Persons.  These must include:

• automated controls to examine each order before entry on a marketplace to prevent the entry of an order which would result in:
  • the Participant or Access Person exceeding pre-determined credit or capital thresholds,
  • a client of the Participant exceeding pre-determined credit or other limits assigned by the Participant to that client, or
  • the Participant, Access Person or client of the Participant exceeding pre-determined limits on the value or volume of unexecuted orders for a particular security or class of securities;
• provisions to prevent the entry of an order that is not in compliance with Requirements;12
• provisions of immediate order and trade information to compliance staff of the Participant or Access Person; and
• regular post-trade monitoring for compliance with Requirements.

The Amendments require the Participant to review and confirm at least annually, that the risk management and supervisory controls, policies and procedures are adequate, maintained and consistently applied, and that any deficiencies have been documented and remedied promptly.

1. Authorization to Set or Adjust Risk Management and Supervisory Controls, Policies and Procedures

Given that in certain circumstances, particular controls may be better placed under the direction of another dealer, proposed new subsection (7) of Rule 7.1 would, on a reasonable basis, allow the Participant to authorize an investment dealer to perform on its behalf the setting or adjustment of a specific risk management or supervisory control, policy or procedure.13   Additionally, the Amendments provide the same flexibility provided by the ETR with respect to the development or implementation of such controls, and thus a Participant would be permitted to use the services of a third party provider that is independent of each client of the Participant, other than affiliates of the Participant.  It is important to note that under the ETR, whether or not a third party solution is utilized, only the Participant is permitted to directly and exclusively set and adjust its supervisory and risk management controls.

The new subsection (8) of Rule 7.1 outlines specific requirements if either an authorization is made to an investment dealer or if a third party provider is utilized.  Either situation requires a written agreement that will preclude the investment dealer or third party from providing any other person control over any aspect of the control, policy or procedure.  Further, unless the investment dealer subject to the authorization agreement is also a Participant, subsection (8) will preclude any authorization with respect to an account in which the investment dealer or a related entity of the investment dealer holds a direct or indirect interest (other than that of commissions received on transactions or a reasonable fee for the administration of the account). 

The policy rationale for permitting a Participant to authorize an investment dealer to perform on its behalf the setting or adjusting of a supervisory and risk management control is the recognition that situations exist where a participant dealer may determine that another investment dealer has a relationship with the ultimate client such that the investment dealer, having better access to information relating to the ultimate client, would be in a position to more effectively set or adjust the control, policy or procedure.  As such, the Amendments only provide for an authorization with respect to accounts where the investment dealer is in fact trading for an ultimate client, and not in circumstances where there is no ultimate client and the trading is being made on a proprietary basis. 

Upon entering into a written agreement pursuant to subsection (8), the Amendments require disclosure of the name and contact information of the investment dealer or third party to the Market Regulator, as well as any change in this information.  The provision of this information will allow the Market Regulator to contact the investment dealer or third party to make enquiries about the application of the controls, policies or procedures to orders or trades in situations when additional information is needed.

If the Participant has authorized to an investment dealer or has utilized the services of a third party provider, the Participant is also required to review and confirm at least annually by the anniversary date of the written agreement with the investment dealer or third party, that the risk management and supervisory controls, policies and procedures are adequate, maintained and consistently applied, that any deficiencies have been documented and remedied promptly, and that the investment dealer or third party remains in compliance with the written agreement.

1. Specific Provisions Applicable to Automated Order Systems

In addition to the trading supervision obligations established by proposed amendments to Rule 7.1 described above, proposed new Part 8 to Policy 7.1 sets out specific supervisory provisions related to the use of automated order systems.  As noted earlier, the risk management and supervisory controls, policies and procedures should be designed to manage the risk associated with access to one or more marketplaces, and if applicable, the use of any automated order system, by a Participant, Access Person, or any client.

The Amendments require that each Participant or Access Person have a level of knowledge and understanding of any automated order system used by the Participant, Access Person or a client of either.  This level of knowledge should be sufficient to allow the Participant or Access Person to identify and manage risks associated with the use of the automated order system.

The Amendments require each Participant or Access Person to ensure that all automated order systems used by the Participant, any client of the Participant or an Access Person are tested in accordance with prudent business practices both initially before being used for the first time, and at least annually thereafter.  This testing must be detailed in a written record in order to clearly demonstrate the testing undertaken by the Participant, Access Person and any third party services utilized to employ the automated order system or the risk management and supervisory controls, policies and procedures.

In establishing the parameters for the monitoring of order flow required under both the ETR and the Amendments, a Participant or Access Person should consider the strategy or strategies being employed by any automated order systems in use, and the potential market impact of defining such parameters inappropriately.  In determining the appropriate scope of the order and trade parameters, policies and procedures the Participant or Access Person should, at a minimum, ensure they are set to prevent an order from exceeding:

• the marketplace thresholds14 applicable to the marketplace on which the order is entered, or
• the limits publicly disclosed by IIROC for the exercise of the power of a Market Integrity Official under Rule 10.9 of UMIR for the triggering of a single-stock circuit breaker or regulatory intervention for the variation or cancellation of trade.15

Generally, it is expected that the risk management and supervisory controls, policies and procedures will be reasonably designed to prevent the entry of orders which would interfere with the operation of fair and orderly markets.  The supervision and compliance procedures adopted by a Participant or Access Person should if applicable, contain detailed guidance on how the testing of client orders and trades is to be conducted to ensure that each automated order system is tested assuming various market conditions both initially and on at least an annual basis going forward. 

Each Participant or Access Person must also have the capability to immediately disable any automated order system used by themselves or any client of the Participant, and thus prevent any orders generated by such system from reaching a marketplace.  This would provide the Participant or Access Person the ability to intervene in the event of a malfunction or a situation where a system was being used improperly.  A Participant or Access Person is ultimately responsible for any order entered or any trade executed on a marketplace, and this does not exclude situations where an automated order system malfunctions or is improperly used.  Such responsibilities include situations where a malfunction causes a “runaway” algorithm even if the malfunction is attributed to an aspect of the automated order system that could not be accessed by the Participant or Access Person for purposes of testing.

1. Variation, Cancellation and Correction of Trades

Previously, Rule 7.11 prevented the cancellation or variation in price, volume or settlement date of an executed trade except in specific circumstances.  Part 4 of the ETR sets out specific rules detailing when a marketplace can cancel, vary or correct a trade, and as such the language of Rule 7.11 has been amended to reflect this new framework.  It now provides for the correction of a trade in addition to the cancellation and variation, and also stipulates that a marketplace can only take such actions:

• with the prior consent of the Market Regulator if the variation, cancellation or correction is necessary to correct an error caused by:
  • a system or technological malfunction of the marketplace itself, or
  • an individual acting on behalf of the marketplace; or
• with notice to the Market Regulator immediately following the variation, cancellation or correction:
  •  prior to the settlement of the trade by:
    • the marketplace at the request of a party to the trade and with the consent of each Participant or Access Person that is a party to the trade, or
    • the clearing agency through which the trade is or was to be cleared and settled, and
  • after the settlement of the trade, by each Participant and Access Person that is a party to the trade.

1. Gatekeeper Obligations with Respect to Electronic Trading

Under the Amendments, Rule 7.1 of UMIR would allow for a Participant to authorize an investment dealer to perform on its behalf the setting or adjusting of a specific risk management or supervisory control, policy or procedure, or for a Participant to utilize the services of a third party provider.  The Amendments add Rule 10.17 of UMIR which establishes certain gatekeeper obligations, and will require that in either of the above situations, the Participant must notify the Market Regulator if either the written agreement which sets out the terms of such arrangements has been terminated, or if the Participant has reason to believe that the investment dealer or third party has failed to remedy any deficiency identified by the Participant in its regular review.

1. Editorial and Consequential Amendments

The Amendments make several editorial or consequential amendments including:

• adding a definition of ETR to Rule 1.1;
• adding clause (c) to Rule 1.2 to note that every term used in UMIR which is defined or interpreted in the ETR (particularly, “automated order system”, “marketplace and regulatory requirements” and “participant dealer”) has the meaning ascribed to it in the ETR;
• deleting phrases in Part 1 of Policy 7.1 to reflect the new rule framework in place under the ETR; and
• adding language to Part 1 of Policy 7.1 to reflect guidance on the use of the “short-marking exempt” designation.16

1. Summary of the Impact of the Amendments

The following is a summary of the most significant impacts of the adoption of the Amendments.  The Amendments:

• ensure that Participants and Access Persons adopt, document and maintain a system of risk management and supervisory controls, policies and procedures reasonably designed to manage the risks associated with electronic trading and access to marketplaces;
• ensure that Participants and Access Persons are effectively supervising trading activity and are accounting for the risks associated with electronic access to marketplaces in their supervisory and compliance monitoring procedures; and
• require an appropriate level of understanding, ongoing testing and appropriate monitoring of any automated order systems in use by a Participant, any client of the Participant or an Access Person.

Under the Amendments, Access Persons have to specifically introduce risk management and supervisory controls, policies and procedures with respect to their direct trading on a marketplace as an Access Person (and not through a Participant).  This parallels a requirement on Access Persons introduced in the ETR.  However, Access Persons presently only have access to one marketplace which operates as a “negotiation” dark pool marketplace.  The requirement will have little practical impact on an Access Person unless they become a subscriber to a new marketplace that is transparent.

There may be impacts to the market in the form of minimal additional latency on some order flow.  Any additional latency will also be dependent on the type of trading strategies in use and the nature of the controls and risk management filters already in place.  To the extent that additional latency may result, it is not expected to have a significant impact on the majority of trading.  Persons employing trading strategies that rely on ultra-low latency connections may have to re-evaluate how they obtain access to a marketplace.

1. Technological Implications and Implementation Plan

The Amendments impose obligations on Participants and Access Persons to ensure that the risks associated with electronic trading are appropriately addressed through the establishment of reasonably designed risk management and supervisory controls, policies and procedures.  The Amendments require pre-trade automated controls to prevent the entry of orders which would result in either the Participant or Access Person, or any client, exceeding pre-determined thresholds which would include credit or capital, as well as limits on the value or volume of unexecuted orders for a particular security or class of securities.

It is expected a Participant would already establish, maintain and apply policies and procedures that establish a system of controls and supervision sufficient  to manage the risks associated with its business in accordance with prudent business practices as required both under section 11.1 of NI 31-103 and under Rule 7.1 and Policy 7.1.  Additionally, those firms providing clients with electronic access to marketplaces would already be subject to similar requirements under the access rules of the various marketplaces to which the Participant or Access Person directs orders.  Technology work and associated costs will likely be required, but the extent of these costs will vary dependent on the level of sophistication of current practices, and the nature of the business activities of the Participant or Access Person. 

On the publication of the Proposed Amendments, IIROC expected that the amendments would become effective on the date IIROC publishes notice of approval of the amendments and that the implementation date would be the later of:

• March 1, 2013, the date the ETR becomes effective; and
• 120 days following the publication of notice of approval of the amendments.

As most of the Amendments are designed to align the requirements of UMIR to those of the ETR, IIROC concluded that, to avoid confusion in the industry, the Amendments should be effective with the introduction of ETR on March 1, 2013.  IIROC and the CSA conducted a survey of members of the Investment Industry Association of Canada (“IIAC”) on implementation of ETR and the Amendments.  That survey indicated that there were no unique requirements of the Amendments (as compared with the requirements that aligned UMIR to the ETR) that could not be implemented on March 1, 2013.  However, the results of the IIAC survey indicated that a limited number of Participants had concerns regarding their ability to complete systems testing by March 1, 2013.

IIROC recognizes that Participants and Access Persons may have significant systems work with respect to the introduction, pursuant to Part 7 of Policy 7.1, of automated controls to examine each order before entry on a marketplace to prevent the entry of an order which would result in:

• the Participant or Access Person exceeding pre-determined credit or capital thresholds;
• a client of the Participant exceeding pre-determined credit or other limits assigned by the Participant or to that client; or
• the Participant, Access Person or client of the Participant exceeding pre-determined limits on the value or volume of unexecuted orders for a particular security or class of securities.

While IIROC expects that Participants and Access Persons will use best efforts to comply with the requirements for automated controls on March 1, 2013, IIROC will allow Participants and Access Persons until May 31, 2013 to complete testing and fully implement such automated controls.  All other requirements of the Amendments must be implemented by Participants and Access Persons by March 1, 2013.

The CSA has followed a comparable approach in respect of the implementation of the requirements for automated controls under ETR.  Reference should be made to Multilateral CSA Staff Notice 23-313 issued by the CSA regarding the implementation date for certain aspects of ETR.17

1. Appendices

Appendix A – Text of Provisions Respectinng Electrronic Traading

Appendix B – Comments Received in Response to Rules Notice 12-0220

• 8Published at http://www.osc.gov.on.ca/documents/en/Securities-Category3/ni_20120228_31-103_unofficial-consolidated.pdf
• 9The term “participant dealer” is defined in ETR as “a marketplace participant that is an investment dealer”.
• 10The term “automated order system” is defined in ETR as “a system used to automatically generate or electronically transmit orders that are made on a pre-determined basis”. As set out in section 1.2(1) of National Instrument 23-103 CP, an automated order system would encompass “both hardware and software used to generate or electronically transmit orders on a pre-determined basis and would include smart order routers and trading algorithms that are used by marketplace participants, offered by marketplace participants to clients or developed or used by clients.”
• 11See section 8 of ETR.  IIROC has sought public comment on the approach which should be adopted to the establishment of acceptable marketplace thresholds.  See IIROC Notice 12-0162 – Rules Notice – Request for Comment – UMIR – Request for Comments on Marketplace Thresholds (May 10, 2012).
• 12“Requirements” include UMIR, applicable securities regulation, requirements of any self-regulatory organization applicable to the activity of the account and the rules and policies of any marketplace on which the account activity takes place. In particular, a Participant or Access Person that uses an automated order system must have appropriate parameters, policies and procedures to detect, prior to entry, an order that is “clearly erroneous” or “unreasonable” and which would interfere with fair and orderly markets if entered. See “Specific Provisions Applicable to Automated Order Systems”.
• 13Under the Amendments, the term “investment dealer” is interpreted as “an investment dealer for the purposes of National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations”.
• 14For further information on “marketplace thresholds” see IIROC Notice 12-0162 - Rules Notice – Request for Comments – UMIR – Request for Comments on Marketplace Thresholds (May 10, 2012).
   
• 15For further information see IIROC Notice IIROC Notice 12-0040 – Rules Notice – Guidance Note – UMIR – Guidance Respecting Implementation of Single-Stock Circuit Breakers (February 2, 2012) and IIROC Notice 12-0258 – Rules Notice – Guidance Note – UMIR – Guidance on Regulatory Intervention for the Variation or Cancellation of Trades (August 20, 2012).
• 16For further information, see IIROC Notice 12-0300 – Rules Notice – Guidance Note – UMIR – Guidance on “Short Sale” and “Short-Marking Exempt” Order Designations (October 11, 2012).
• 17Published at http://www.osc.gov.on.ca