As competitive alternative marketplaces begin to vie with the Toronto Stock Exchange, Canada has gone through in two years what the United States took a decade to achieve in fostering electronic trading platforms, regulators say.
These new marketplaces are draining trading volume away from traditional exchanges; indeed, some of them are stock exchanges, while others are electronic communications networks operated by broker-dealers in the U.S. and investment dealers in Canada. They have changed the speed of trading.
And now the pace of regulatory change is quickening, too. Last week, the Canadian Securities Administrators released a discussion paper on alternative trading systems and market structure in Canada. In November, a committee of regulators and market participants is slated to deliver its recommendations on trade-through protection, a move made more urgent by the proliferation of trading venues.
Serge Boisvert, a regulatory analyst with the Autorité des marchés financiers, noted yesterday at a summit on trading compliance and best execution sponsored by the Strategy Institute that many of these updates date back to 2005, including those concerning new registration requirements and soft-dollar arrangements.
One update at the top of the list is a redefinition of best execution to include not just best price, but speed of execution, certainty of execution and overall cost of trading. But there are other considerations, such as order size, market impact and opportunity costs, as well as liquidity. The key duty is attaining “the most advantageous execution terms reasonably available under the circumstances,” Boisvert says.
However, this will not be a trade-by-trade activity, he adds. Rather, dealers and advisors “should be able to demonstrate that they have adhered to their policies and procedures to achieve best execution.”
But the multiplication of marketplaces is forcing another change. Until now, best execution has been a responsibility of the investment dealer, says Felix Mazer, policy counsel for the Investment Industry Regulatory Organization of Canada. That will shift to the marketplace itself. As a result, marketplaces such as the TSX will have to route orders to other marketplaces if they provide better prices, re-price the order or reject it.
The new regime is intended to ensure that visibly displayed orders do not suffer trade-throughs. That, says Tracy Stern, assistant manager, market regulation, with the Ontario Securities Commission, builds both investor confidence and, hence, price discovery. Visibility applies to the full depth of the order book — all the orders in the market. That means, a dealer cannot take out the top-of-book quote and then trade at inferior-priced quotes. Orders must be filled in sequence of best price, unlike the United States, where the top-of-book system allows cherry-picking of inferior-priced quotes.
Similarly, says Mazer, institutional investors and their dealers cannot book a trade on a U.S. exchange before hitting the better bids and offers in Canada. “It’s the big blocks we want to keep here,” he explains, while retail investors would be allowed to trade through to the U.S. market.
But the order protection rule does not apply to invisible orders, such as are placed on so-called “unlit” or “dark exchanges” where institutional investors frequently seek to trade large blocks while minimizing their market impact — signals to traders that someone is buying or liquidating.
There are other exemptions. One would be if a dealer decides to use direct access orders, in which case, best execution obligations revert to the dealer. Another would occur if a marketplace or dealer declares self-help when trading or market data seems to be delayed. A third would occur in highly volatile markets, where an investor could trade through the best price, provided it is within the best bid-offer spread.
Transaction cost analysis
While there is a regulatory requirement for best execution, there is a business case, too. Imagine a manager with a 7% return being able to boost that to 7.5%. One way to do that is to use transaction cost analysis, says Etienne Phaneuf, managing director, sales and trading, with ITG Canada. The goal is “measuring the transaction costs so that we can determine the drag on returns.”
Trading costs may range from 50 basis points to 300 basis points. Most clients, he suggests, look at trading commissions. But that hardly begins to capture all the costs. Between the time a portfolio manager decides to make a trade and a trader receives it, there is a huge opportunity cost, augmented by the fact that, as Phaneuf notes, the markets are almost always going against the trade. “The big costs happen before the order even gets to the trading desk,” he argues.
Then there is the gap between a trader sending an order and a broker receiving it. Finally, there is the actual execution. Executing an order leads to market impact costs, which Phaneuf calls the price of liquidity, which is what an investor pays to get an order of a certain size filled over a certain trading period.
Transaction cost analysis can also help determine whether the trader should resort to an algorithmic trading strategy or instead have a broker execute an order. What’s more, it can benchmark brokers who are good at execution.
But, Phaneuf says, only four or five Canadian institutional investors have fully embraced transaction cost analysis. Another 30 or 40 may use it, but they use it more as “check boxes” to fulfill regulatory requirements.
“The majority of Canadian firms,” he says “are leaving money on the table by not engaging in transaction cost analysis.”
(10/08/09)