Summary

The Investment Industry Regulatory Organization of Canada (“IIROC”) has prepared a study (“Trends Study”) that sets out certain information with respect to recent trends in trading activity of listed securities on Canadian equity marketplaces1 and, in particular, short selling and failed trades in the three-year period May 1, 2007 to April 30, 2010 (“Study Period”). A copy of the Trends Study is available on the IIROC website (www.iiroc.ca) under the heading “News Room” and the sub-heading “Publications”.

During the Study Period:

• overall, the average number of trades per day increased significantly;
• the trends in trading activity varied markedly between marketplaces and types of securities with increases in trading activity concentrated on the Toronto Stock Exchange (“TSX”) with securities inter-listed with an exchange in the United States (“inter-listed securities”) and exchange-traded funds (“ETFs”);
• rates of short sales were relatively constant throughout; and
• rates of trade failure generally declined.

Other Empirical Studies by IIROC

The Trends Study built on or accompanies other studies on short sales and failed trades undertaken by IIROC including:

• a study of failed trades undertaken by Market Regulation Services Inc. in 2006 that, among other findings, determined that a short sale had a lower probability of failing than trades generally and that the principal reason for trade failures was administrative error (“Failed Trade Study”);2
• a prior study of trends in trading activity, short sales and failed trades that covered the period May 1, 2007 to September 30, 2008 and generally found trends consistent with those identified in the Trends Study (the “Prior Study”);3
• an analysis of the impact of the prohibition on the short sale of certain financial sector issuers listed on the Toronto Stock Exchange (“TSX”) that were also listed on an exchange in the United States that was in effect between September 22, 2008 and October 8, 2008 which found that the prohibition had a significant impact on market quality by reducing liquidity and increasing “spreads” while not having any effect on price volatility;4 and
• a study of the relationship between price movement and short selling activity during the Study Period for securities listed on the TSX Venture Exchange which suggests that the steep price decline observed between July of 2008 and December of 2008 was neither caused by nor exacerbated by short selling activity and that the “tick test” was not an effective tool to restrict significant and rapid, system declines in prices.5

Taken together, the results of the Trends Study and the other empirical studies indicate that the Canadian market has not had the problems with short sales, particularly naked short sales, and failed trades that may have been evident in other jurisdictions.

Purpose of the Trends Study

Since the fall of 2008, securities regulators in Canada and abroad have 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, 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.

The analysis underpinning the Prior Study and the earlier Failed Trade Study was used in the formulation of the amendments in October of 2008 to the Universal Market Integrity Rules (“UMIR”) regarding short sales and failed trades.6 All of the empirical studies have informed the consideration of other proposals for the amendment of UMIR respecting short sales and failed trades that have been published for public comment concurrent with the issuance of this Rules Notice.7 In particular, the proposed amendments would:

• repeal the restrictions on the price at which a short sale may be made;
• require, subject to certain exceptions, that a Participant or Access Person to have made arrangements to borrow securities that would be necessary to settle any short sale prior to the entry of the order on a marketplace if:
  • the security has been designated by IIROC to be a “Pre-Borrow Security”,
  • the client or non-client account on whose behalf the short sale order is being entered has previously executed an “Extended Failed Trade” (a “failed trade” that was not rectified within ten trading days following the date for settlement contemplated on the execution of that trade), or
  • the Participant had executed, as principal, an “Extended Failed Trade” in that particular security,
• require a sell order from a short position to continue to be marked “short sale” but introduce an exemption from the short sale marking requirements for orders from certain types of accounts;
• change the use of the “short exempt” order designation to provide that it be used in connection with orders for the purchase or sale of a security by an arbitrage account, an account of a person with Marketplace Trading Obligations or certain institutional accounts that adopt a “directionally neutral” strategy in the trading of securities; and
• make a number of administrative and editorial changes.

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

Summary of the Findings

During the Study Period, there was no “negative” change in the pattern of short selling or trade failures from the findings of the Prior Study. In particular, during the Study Period:

Trading Activity

• the average number of trades per day increased significantly over the Study Period, with more modest and less consistent increases in average daily volume and value;8
• the number of trades in securities listed on the TSX increased throughout the Study Period across all marketplaces trading those securities, with the increase concentrated in the trading of inter-listed securities and ETFs;9
• while the number of trades in securities listed on TSXV or CNSX varied significantly throughout the Study Period, the data showed a drop in daily trading volumes from the beginning of the study in 2007 to 2008 with increases in the daily volume increased from the lows noted in 2008 over the latter part of the Study Period;10
• in periods of increased “market stress” (“Market Stress Period”)11 trading activity, as measured by number of trades, exceeded the average for the Study Period;12
• securities which were exempt from the tick rule did not decline in price as fast or as far during Market Stress Periods as securities that were subject to the tick rule;13

Short Sales

• there was no significant change over the Study Period in the pattern of short selling in comparison with the trading of securities generally;
• the granting in July of 2007 of the exemption from the tick rule for the short sale of an inter-listed security has not had any discernable effect on the pattern or attributes of short sales of inter-listed securities (other than a slight increase in the proportion of trades that are short sales);14
• in a Market Stress Period:
  • there is generally a lower than average level of short selling activity on TSXV and CNSX,15
  • there is a slightly higher rate of short-selling on the TSX,16 and
  • the average volume of a short sale of a security (other than a TSXV-listed security) tends to be lower than the volume and value of short sales generally;17
• the more “senior” the security, the higher the proportion of short sales;18
• short selling activity accounts for a disproportionate level of the trading activity on the transparent ATSs (possibly indicating a concentration of arbitrage and algorithmic trading);19
• during the Study Period:
  • two-thirds of issues on the TSX reported a month-end short position, as compared to less than a quarter of the issues on TSXV and one-sixth of the issues on CNSX,
  • short positions in TSXV-listed securities “turned over” faster than for TSX-listed securities,20
  • monthly short positions amounted to approximately 13% of trading volume in TSX-listed securities as compared to approximately 1% of trading volume for securities listed on TSXV and CNSX, and
  • the average short position for a security represented the volume of 1,413 average trades on TSX for a TSX-listed security as compared to 13.7 average trades on TSXV for a TSXV-listed security and 1.4 average trades on CNSX for a CNSX-listed security;

Failed Trades

• over the Study Period:
  • the number of failed trades, as a percentage of the overall number of trades, has generally been declining,21
  • on average, 5.28% of failed trades are closed out through the execution of a “buy-in” on a marketplace, and
  • the accumulated value of failed trades, as a percentage of the value of trades, has generally been declining;22 and
• “market stress” did not increase the rate or value of trade failures.23

• 1The study does not analyze the trading on markets outside of Canada of securities that are also listed on a Canadian marketplace. The study does not analyze the trading of securities “over-the-counter” in Canada or in another jurisdiction.
• 2 For a more detailed discussion of the Failed Trade Study and its results, see Market Policy Notice 2007-003 – General – Results of the Statistical Study of Failed Trades on Canadian Marketplaces (April 13, 2007).
• 3Reference should be made to IIROC Notice 09-0037 - Administrative Notice – General – Recent Trends in Trading Activity, Short Sales and Failed Trades (February 4, 2009).
• 4Reference should be made to IIROC Notice 09-0038 - Administrative Notice – General – Impact of the Prohibition on the Short Sale of Inter-listed Financial Sector Issuers (February 9, 2009).
• 5Reference should be made to IIROC Notice 11-0077 - Rules Notice – Technical – Price Movement and Short Sale Activity: The Case of the TSX Venture Exchange (February 25, 2011).
• 6For particulars of the recent amendments, see IIROC Notice 08-0143 - Rules Notice – Notice of Approval – UMIR – Provisions Respecting Short Sales and Failed Trades (October 15, 2008).
• 7IIROC Notice 11-0075 - Rules Notice – Request for Comments – UMIR – Provisions Respecting the Regulation of Short Sales and Failed Trades (February 25, 2011).
• 8The average number of trades per trading day increased from 481,041 in May of 2007 to a high of 1,256,763 in April of 2010 with an average over the Study Period of 841,421 trades per day. Each of the 7 months between October of 2008 and April of 2009 had a number of trades in excess of the Study Period average indicating that the trend towards increased trading activity is continuing notwithstanding the turmoil in the markets generally. For the 17-month period ended September 30, 2008 covered by the Prior Study there were an average of 634,330 trades per day.
  With respect to average daily volume, the Study Period average was 700,755,398 with a high of 971,097,043 in April of 2010 and a low of 458,400,292 in August of 2008 (when volume on the TSXV was at a low of 107,602,589). 4 of the 7 of the months between October of 2008 and April of 2009 had volumes in excess of the Study Period average. With respect to average daily value, the Study Period average was $7.37 billion with a high of $9.59 billion in September of 2008 and a low of $5.61billion in January of 2009. With the exception of October of 2008, the months between October of 2008 and April of 2009 had average daily trade value below the Study Period average (notwithstanding above average number of trades and volume which reflects the general decline in price levels).
• 9The TSX averaged 687,761 trades per day over the Study Period (from a low of 445,945 in May of 2007 to a high of 1,030,801 in October of 2008 (with all 7 of the months between October of 2008 and April of 2009 having a number of trades in excess of the Study Period average). The number of trades in ETFs increased from 3,706 per day in May of 2007 to a high of 39,888 in November of 2008 for an overall average of 13,779 for the Study Period. The number of trades in inter-listed securities increased from 245,175 per day in May of 2007 to a high of 614,047 in March of 2009 for an overage average of 412,225 for the Study Period.
• 10TSXV averaged 25,851 trades per day during the Study Period (with the number of trades declining from 34,944 in May of 2007 to 15,416 trades per day in April of 2008, increasing to 35,484 trades per day by April 2010 with a low of 12,344 trades per day in November of 2008). CNSX averaged 94 trades per day during the Study Period (with the number of trades declining from 152 in May of 2007 to 28 trades per day in April of 2009. Both TSXV and CNSX had below the Study Period average number of trades in each of the 7-months between October of 2008 and April of 2009.
• 11For the purposes of the Prior Study, six of the months (August of 2007 and January, March, July, August and September of 2008) experienced elevated levels of market stress across both indexes. For the purposes of this Study, the months October of 2008 to April of 2009 were included. During the Study Period, the average daily point change in the closing index level of the S&P/TSX Composite was 134.6 points, or 1.201% of the average closing index level (as compared to 129.87 points or 0.958% of the average closing index level found in the period covered by the Prior Study). For the S&P/TSX Venture Composite Index, the average daily point change in the closing index level was 20.87 points or 1.210% of the average closing index level (as compared to 28.94 points or 1.137% of the average daily point change in the closing index level found in the period covered by the Prior Study). The average number of points (and percentage) between the average of the daily high and low index levels for the S&P/TSX Composite was 220.84 points of 1.974% of the daily average of the high/low index level (as compared to 211.43 points or 1.558% of the daily average of the high/low index level found in the period covered by the Prior Study) and, for the S&P/TSX Venture Composite Index, 29.41 points or 1.721% of the daily average of the high/low index level ( as compared to 39.88 points, or 1.556%, found in the period covered by the Prior Study). For the purposes of this Study, five months (September of 2008 to January of 2009) experienced elevated level of market stress across both indexes.
• 12The average daily number of trades in a Market Stress Period was 937,013 or approximately 11% above the overall Study Period average of 841,421.
• 13Reference should be made to Chart 2 - Index Levels Relative to Closing Level on May 1, 2007 in Trends in Trading Activity, Short Sales and Failed Trades.
• 14For inter-listed securities, short sales generally accounted for between 28% and 35% of trades. With the granting of the exemption from the tick rule, the proportion of short sales in trades of inter-listed securities generally increased to the 35% to 40% range (with a high of 42.2% in February 2010). This increase in the proportion of short sales was anticipated on the granting of the exemption.
• 15On the TSXV, short sales accounted for 2.3% of trades in a Market Stress Period as compared to 4.4% throughout the Study Period. On CNSX, short sales accounted for 7.3% of sales in September of 2008 significantly above the Study Period average of 3.5% of trades. However, the averages for the other four months were significantly lower such that the average for a Market Stress Period was only 2.3%.
• 16On the TSX, short sales accounted for 27.7% of trades in a Market Stress Period as compared to 28.4% of trades throughout the Study Period.
• 17 During a Market Stress Period, short sales had an average volume which was generally less than the Study Period average for short sales ranging from 9% less for ETFs, 17% less for inter-listed and 19% for other securities on the TSX and 9% less for securities traded on CNSX. For securities TSXV-listed securities, short sales during a Market Stress Period had a volume 10% higher than the Study Period Average.
• 18Over the Study Period, short sales of securities listed on the TSX accounted for 28.4% of trades (33.2% of inter-listed securities, 24.3% of ETFs and 21.5% of other TSX-listed securities) as compared to 4.4% of trades of TSXV-listed securities and 3.5% of trades of CNSX-listed securities.
• 19For the “new” marketplaces which publicly display order information, the proportion of short selling ranged from 38.9% of trades on Chi-X, 36.2% of trades on Pure Trading, 27.6% of trading on Alpha to 30.5% of trades on Omega (which during much of the Study Period limited trading to securities which were exempt from the tick rule.) For MATCH Now, which operates as a non-transparent marketplace, short selling accounted for only 13.8% of trades.
• 20The turnover rate is determined by dividing the volume of short sales during a month by the outstanding volume of short positions at the end of the month. On average over the Study Period, the short position on the TSX turned over every 0.61 of a month as compared to 0.33 of a month for the TSXV and 0.86 of a month on CNSX.
• 21Over the Study Period, “initiated buy-in notices” received by CDS represented 0.22% of trades (ranging from a high of 0.38% in December of 2007 to a low of 0.13% in March of 2008).
• 22Over the Study Period, the value of accumulated fails as a percentage of trade value was 1.67% (ranging from a high of 2.69% in May of 2007 to a low of 0.73% in March of 2009).
• 23During the months that were identified as part of a Market Stress Period, the value of accumulated fails as a percentage of trade value was 1.48% or approximately 11% less than the overall average for the Study Period of 1.67% and the proportion of initiated buy-ins as a percentage of trades was 0.17% as compared to 0.24% for the Study Period overall.