Call of the Wild

Relatively unscathed in the global economic crisis, conservative and risk-averse Canadian firms are considering dark liquidity and high-frequency trading. By Michael Shashoua

While dark liquidity and high-frequency trading are less prevalent in Canada compared to the US, rule proposals from Canada's securities regulators appear to be pushing major Canadian trading venues to enhance and upgrade their operating technology, such as matching engines or other systems accommodating high-frequency traders.

The Order Protection Rule, expected to be introduced as legislation in 2010, would allow dealers to opt out of trade-through protection if they use recognized smart order-routing protection. Such dealers would be able to mark orders "immediate action order" (IAO) so the market immediately executes or books the order. This rule would replace Canada's current Best Price rule, a self-regulatory organization (SRO) rule that is more like a "best efforts" requirement. Rule proposals intended for adoption in all Canadian provinces are coordinated through the Canadian Securities Administrators (CSA) but have to be adopted separately in each province, with Ontario's decision having the most impact since it is home to the primary market of Toronto.

In addition, the Ontario Securities Commission currently has its "Memorandum of Understanding Oversight of Exchanges and Quotation and Trade Reporting Systems" under review by the Ontario Minister of Finance, whose decision is required by Dec. 1. The Investment Industry Regulatory Organization of Canada (IIROC) and the CSA consultation paper, Dark Pools, Dark Orders and Other Developments in Market Structure in Canada, published Sept. 30, is open for public comment through Dec. 29. The paper analyzes the impact of some of the newer Canadian venues that have introduced more of this type of trading activity.

In the Canadian market, dark liquidity is "extremely underdeveloped," says Jos Schmitt, CEO of Alpha Trading Systems Ltd. Dark liquidity represents less than 2 percent of the market, compared to about 10 percent in the U.S. and 5 percent in Europe, he says. Whether the practice is dark liquidity, high-frequency trading, co-location or direct market access (DMA), those providing those services or access should be required by regulation to clearly explain how they work, says Schmitt. "People typically think that some markets will provide price improvement, and they can be lit or dark, but then they're not aware of how other market participants can take advantage of some information, such as high-frequency traders," he says. "When you think you get better execution, you don't because there was some form of information leakage."

Co-location, which supports high-frequency trading, is likely to draw further attention from Canadian regulators, says Tal Cohen, CEO of Chi-X Americas, which includes the Chi-X Canada alternative trading system (ATS), and is part of Instinet Group. Chi-X Canada has offered co-location since 2008 and has built out its datacenter to accommodate the practice. "Markets across the globe are trying to get a handle on what sponsored access and co-location means to their markets," he says. "So far, it's meant tighter spreads and more liquidity to some extent, but all are aware of potential systemic risk that co-location and sponsored access present."

High-frequency trading is driving changes in costs and systems used for order flow, according to Cohen. "Some on the brokerage side have grown concerned about the increasing costs to execute," he says. "They are now finding themselves being more active than passive regarding their own order flow. They have seen a shift in the composition and costs associated with their order flow."

Omega ATS, another competitor of Canada's primary market, the Toronto Stock Exchange, pursues increased speed of execution, says Mario Josipovic, president of Omega ATS. "We are always concerned that our current latency is as low as or lower than the other marketplaces," he says. "It's one thing for a customer to say they want us to have 800 microseconds on our internal roundtrip or they won't use us, but it's another when three or four existing clients say that the speed is pretty good, but they can give more flow if we optimize it. We're just on the cusp of getting increased high-frequency traffic and very open to upgrading our matching engine if required."

Although Omega ATS has not yet published performance metrics, it reports volumes of about 500,000 shares daily, with 100,000 separate orders each day. Omega is "just now completing connections to the last of the major dealers in Canada," adds Josipovic. "We are in early discussions with high-frequency firms wishing to post liquidity to Omega. This constituency is most focused on ultra-low latency, given its style of trading."

Chi-X Canada, like its competitors, offers investors an alternative market structure. "From our perspective, there is a lot on the table regarding trade-through, valuation of dark pools and continued education on high-frequency trading," says Cohen. "We have carved ourselves a niche and now need to execute and make sure we're providing the community with value."

Sell-side market participants, in turn, will have to react to the technology improvements the venues are making in response to regulation, observes Robert Young, president and CEO of Liquidnet Canada, the Canadian unit of block trading provider Liquidnet. "There has been a wave of technology installation to access these other marketplaces," he says. "The next wave is intelligent access for the sell side. The sell side needs to go through the next wave, to have algorithms and access technology that detects the more toxic order flow out there and protects their clients." -->