Canada’s nascent dark trading market is about to see more regulation that could limit its growth and possibly drive business across the border, into the U.S.
The pending regulations and rule changes, proposed by Canadian regulators to govern dark liquidity in Canada, are likely to have a negative impact on the Canadian equities markets, said Doug Clark, head of market structure at ITG Canada.
"I’m surprised the regulators are going in this direction with more regulation," Clark said. "The rest of the world is not. The U.S., U.K. and Mexican markets are moving towards fewer rules around dark orders and the dark markets."
Comments on the new proposals are due Oct. 27, with a final ruling and implementation expected six to nine months after that.
Canadian thinking goes that Northern investors are better served when trading occurs in the public or lit markets, rather than in dark venues. Regulators worry that if too much trading occurred off-board, price discovery would be hampered and investors harmed.
According to the latest data from the Investment Industry Regulatory Organization of Canada, total dark pool volume in Canada is roughly 3 percent of total daily volume. In the U.S., dark pools see about 14 percent of average daily volume.
At the end of July, IIROC and the Canadian Securities Administrators jointly issued a notice titled "Regulatory Approach to Dark Liquidity in the Canadian Market." In the report, the regulators proposed minimum sizes and price improvement for dark orders. They also commented that an order should go first to lit venues before being sent to dark ones.
In particular, the notice suggested that a minimum size for passive dark orders should be no less than 50 board lots (5,000 shares) or C$100,000 in value. Also, orders deemed small-under 50 board lots or C$100,000 in value-should only be allowed to interact with dark orders if they receive price improvement of at least one tick, or half a tick if the spread is only a single tick. The price improvement does not consider any maker/taker pricing economics, meaning the real price improvement might be considerably less.
Clark expects the rule changes to have a profound impact on existing Canadian market structure, significantly differentiating the landscape there from other international markets, particularly the United States’. He said these new rules only look at child orders and not the entire parent order, so if an order is sent to several marketplaces, the rules are misapplied.
"The new proposal will not allow small passive dark orders that are part of an order placement strategy for a larger parent order," Clark said. "Given the increasing fragmentation of our markets and the prudent multi-posting nature of sophisticated algorithms and smart order routers, this rule actually imposes restrictions not just on smaller orders but on larger ones, as well. The consequence of such a rule-intended or otherwise-would be to greatly restrict dark pools and dark order types outside of block matching facilities."
The regulators believe that disallowing smaller child orders from being placed in dark trading facilities will result in more passive resting orders being placed on the visible markets. But given the sophisticated nature of order routing, most of these orders are likely being represented in the visible market already, he said.
"The real outcome is more likely to have these potential dark orders sitting within a liquidity-seeking algorithm, where they don’t represent instantly achievable liquidity for contra-side orders," Clark said. "Or in the case of stocks listed on both Canadian and U.S. markets, these orders will likely port to U.S. venues."
Todd Lopez, managing director in the equities group at Goldman Sachs, seconded Clark, noting that there are a number of interlisted equities that trade in both Canada and the U.S. that could be affected, creating a regulatory arbitrage trade.
"There are a number of interlisted names that trade in both Canada and the U.S., and one could theorize in an environment where there are certain capabilities in the U.S. that there might be an effect on what percentage of an interlisted name’s volume would trade in the U.S. versus the Canadian market," Lopez said. "Potentially, it could drive volume in particular names to the U.S., rather than Canada."
Also, Lopez said, smaller Canadian companies that are not as liquid as some of larger names could be affected by the minimum-size requirements.
"Smaller illiquid stocks could be impacted," Lopez said. "A 50-board lot minimum-size requirement across the board isn’t necessarily the most effective way to ensure orders that are subjected to this rule trade in the most efficient matter."
He thinks for smaller illiquid Canadian stocks, the regulators might consider changing the minimum lot size. Lopez did not say what that size might be.
"The proposed rules, if passed in current form, could make it more difficult for dark venues to gain market share," he said.
As for the buyside, they are in a standby situation, as there is still some time remaining before final rules are passed and implemented. Michael Thom, head trader at Vancouver, B.C.-based Genus Capital Management, said the new rules will impact dark pool trading, but just how remains to be seen.
Genus sends about 10 percent of its order flow to dark venues.
"Regulators need to be 100 percent aware of the responses of participants to their proposed regulations," Thom said. "What could happen is anyone’s guess, but realistic responses need to be examined in advance of any regulatory action."
