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25 April 2012 | Volume 3 | Issue 11

The Blotter presents ITG’s insights on complex global market structure, technology, and policy issues.

CONTRIBUTORS Nicholas Thadaney Chief Executive Officer & Global Head of FX +416.874.0737 Ian Williams Managing Director, Sales & Trading 416.874.0742 Doug Clark Managing Director, Liquidity Research 416.874.0760

CONTACT Asia Pacific +852.2846.3500 Canada +1.416.874.0900 EMEA +44.20.7670 4000 United States +1.212.588.4000

Policing the Dark: Likely Impacts of New Canadian Regulation On Friday April 13th 2012, the CSA and IIROC published their final dark pool regulations (“Provisions Respecting Dark Liquidity”) along with an AntiAvoidance Provision (released for comment). ITG’s Canadian market structure experts weigh in. In a nutshell the rules state: 1. Visible orders must have priority over dark orders on the same venue. 2. Dark trades for 50 standard trading units or less (i.e. 5,000 shares or less) must give the active participant at least a full tick price improvement over the Canadian NBBO (or ½ tick if the spread is only 1 tick wide). This means that an order for 5,000 shares requires full price improvement but arguably an order for 5,001 shares does not. (note that later in the document on page 11, section 2.5, the regulators mention that you do not have to provide price improvement to orders valued GREATER than $100,000). 3. The regulators have granted IIROC the ability to impose a

minimum size on passive dark orders should they deem it necessary at some point in the future (at the present time, no minimum size has been specified). 4. Small orders – those under 5,000 shares and $100k Cad in value – originating in Canada cannot trade on U.S. dark venues unless they achieve the same 1 tick price improvement after foreign exchange conversion. ITG is supportive of any regulatory proposals that seek to enhance the quality and integrity of our Canadian markets. We believe that the intent of our regulators, in the proposals related to dark liquidity, was to ensure that we maintained a strong price discovery mechanism and to prevent the degree of internalization of retail order flow that has been seen in the US markets. While we

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may not agree with some aspects of the proposals, we are very supportive of their objectives in ensuring the quality of our market, both lit and dark. This is an extremely complicated issue that will have both intended and unintended consequences. Market participants should ensure that they take time to fully understand the impacts on their order handling processes and trading costs. We have combined the impact of the Notice regarding Provisions Respecting Dark Liquidity and Anti-Avoidance as they are related and cannot be considered in isolation. We believe that the AntiAvoidance rules will be implemented at the same time as the Provisions Respecting Dark Liquidity. Having studied the proposals, we believe the most likely impacts are as follows: Dark Trading will continue to offer significant benefits to Canadian investors “IIROC has acknowledged that dark liquidity in Canada has to date not had a negative impact on price discovery. The Amendments are designed to ensure that the anticipated growth of dark liquidity does not have such a negative impact.” a. HFT liquidity providers will lose their incentive to participate passively in Dark trading. The impact on each venue will depend on the amount of resting liquidity provided by institutions vs. HFTs. We believe that most institutional traders will view this as a positive change for the quality of liquidity in dark pools. b. We expect an increase in active (Retail) order flow to Dark markets as the incentives have shifted in their favour. Active orders will now earn a minimum of a one tick price improvement (or a ½ tick of price improvement if spread is only 1 tick)


vs. 10 or 20 % of spread before as well as benefit from a lower cost to execute. Based on several acknowledgments in the notice by IIROC, we believe it is signaling that it will enforce Best Execution obligations regarding order routing. It is clear that IIROC has acknowledged the benefits of institutional order flow interacting with retail order flow (“small orders”). “IIROC notes the concern with respect to potential loss of passive liquidity to other jurisdictions. However, the offsetting factor will be that the opportunity to obtain meaningful price improvement may attract more active order flow to “check” the dark pools before being entered on a transparent market” c. There will be an increase in low dollar and liquid stock trades > 5,000 shares matching in the dark as this flow can/may be internalized vs. prop or HFTs at-the-touch. At-the-touch refers to the ability to step in front of a visible order and match the dark trade at the NBBO without providing priority to the visible order. This means reported Dark volumes will increase, but a portion of the increase will come from growing internalization / intermediation and not from increased matching of natural contra order flow. Biggest Loser is the Canadian “small order” (<5,000 shares) or the Canadian retail order a. The rules make it very problematic for most dealers in Canada to access price improvement and liquidity in US markets. We believe dealers with small order flow will avoid sending this flow to the US and trade it in Canada. b. Dealers with large retail flow could see their costs of execution and or technology rise significantly as they work to implement the new provisions.

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c. Retail size orders originating in Canada will be significantly disadvantaged in both liquidity and price improvement when accessing US markets. US “small orders” will be able to access both Canadian and US liquidity and the benefits of price improvement from increased competition for order flow. d. Small institutional order flow or programs will be significantly disadvantaged as any active orders < 5,000 shares will execute only in Canada and will not access interlisted liquidity and price improvement opportunities. Biggest Winner(s) are HFTs and their Canadian Exchange and ATS partners a. On average, the effective economic spread which HFTs earn as compensation for providing liquidity has been significantly increased for “small order” flow as this flow will be forced to trade in Canada. Orders will check the Dark in Canada and then cross the spread on a lit market feeding the HFTs. This means orders that don’t match in the Dark in Canada will execute at a higher fee and spread cost than previously. b. The exchanges will benefit from the repatriation of “small orders” from US venues. The exchanges in Canada have evolved to the point where the same speed and technology advantages that exist for HFTs in the US exist in Canada. Combine this with more active flow and the maker/taker models and the Canadian Exchanges will benefit from increased volumes. We can expect more innovation from Canadian marketplaces that is designed to compete for order flow and provide passive fills and rebates for the HFTs Some Good and Some Bad for Institutional Investors a. We expect institutional investors to gain better access to active order flow as it checks the Dark (1(b) above), but at a higher cost.


Currently passive orders pay 20 mils on a 0.01/spread and they will now pay 50 mils on the same 0.01/spread to access active order flow in a Dark venue. This means the cost of avoiding the HFT intermediary has risen from 20 mils to 50 mils. We expect the reaction to this to be fairly muted as many of our institutional clients were moving towards a mid-point only match to avoid leakage from the post trade dissemination of a 20/80 mil split. This outcome will rely heavily on whether or not IIROC monitors the routing practice of dealers who have often ignored the benefits of checking the dark for liquidity. b. Given that we expect the HFTs to be a big winner we anticipate that competition for the bid/offer quote will intensify as book priority will have access to “small orders” which are considered the most valuable by HFTs. This means institutional investors could be faced with more competition for passive fills and see their active fill rates increase, forcing them to cross the spread more often which could increase trading costs. c. Finally, we expect the institutional investor to lose some access to order flow greater than 5,000 shares. This order flow will be internalized against prop flow or HFT flow and monetized vs. executing on a lit exchange. Other complexities participants will need to consider. 1. Will the regulators address broker preferencing and maker/ taker models which are the root cause of internalization and the lack of participation in Dark trading by some market participants who place their interests before their Best Execution obligations? 2. US dealers will have access to US markets and Canadian markets and could enjoy a significant advantage for “small orders” Will this flow execute in the US at more competitive prices and

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exchange fees or flow to Canada? 3. Bifurcation of markets by regulations will lead to increased arbitrage opportunities. We expect to see spreads and opportunities for interlisted arbitrage widen as participants look for creative ways to monetize their order flow from as a result of the disadvantages applied to Canadian orders. 4. Will the dealer community be able to implement the complex routing and technology solutions required to meet the new


regulatory requirements by October 10th or will they just shut down routing to US venues? The regulators have overlooked the impact on market participants to make the necessary changes to comply with the new rules. 5. Will the regulators follow through with their commitment to monitoring and researching the impact of their amendments on Dark Trading and take a quantitative approach vs. a consultative approach?

Š 2012 Investment Technology Group, Inc. All rights reserved. Not to be reproduced or retransmitted without permission. 42512-22161 The opinions, positions, and/or predictions taken or made in this document reflect the judgment of the individual author(s) and are not necessarily those of ITG. These materials are for informational purposes only, and are not intended to be used for trading or investment purposes or as an offer to sell or the solicitation of an offer to buy any security or financial product. Nothing contained herein should be relied upon as a representation, guarantee, or warranty as to the reasonableness of the assumptions or the accuracy of the sources used by the author(s). These materials do not provide any form of advice (investment, tax or legal). ITG Inc. is not a registered investment adviser and does not provide investment advice or recommendations to buy or sell securities, to hire any investment adviser or to pursue any investment or trading strategy.

Policing the Dark: Likely Impacts of New Canadian Regulation