October 2016

Canadian Microstructure Review

Third Quarter, 2016
HIGHLIGHTS

Canadian Regulators proposing a variety of changes to rules around fund

distribution
More marketplace segmentation and complexity headed our way
NASDAQ Canada Dark Pool (CXD) on the horizon

Integration of derivative and equity clearing house may bring cost savings to

the street

Trading Costs revert to more normal levels after spiking in early 2016

THE STATE OF THE NORTHERN UNION

th

With a looming election south of the 49 parallel and unprecedented numbers of

Americans searching Canadian real estate on the interwebs, we suspect that interest in
Canadian market structure should naturally be reaching all time highs. Those observers
of the Canadian market will quickly discover a market that continues to evolve at near
record pace. In this quarters update, two key themes will emerge the continuing
attempt by marketplaces to segment flow, and a variety of regulatory changes that will
greatly impact the retail distribution of asset management products that has the potential
to disrupt that market.
We start with a view from 30,000 feet and move slowly into the weeds.
Distribution is King
Over the past few years, independent Canadian Asset managers have expressed
growing concern about their inability to easily distribute product. As the bank owned
dealers have grown their footprint in the retail market, and greatly improved their in-house
cross selling efforts, a growing percentage of the dollars that enter the bank system end
up in product offered by the banks own asset management arm. This has lead to several
asset managers looking at products like ETFs and PTFs to aid in distribution. A wave of
coming regulatory change is likely to greatly impact how such products are sold to the
public.
First off, the Canadian Securities Association (CSA) will be hosting a series of round
tables, across the country, to debate moving retail IAs to a best interest standard. As
such, brokers would need to be able to defend their selection of funds for clients, and
would likely be expected to explain why they selected the fund with the highest MER, the
biggest trailer fees, or almost exclusively their own in-house products. One would
reasonably expect that funds which have competitive fee structures and / or superior
performance should benefit from such a rule.
On top of such a best interest standard, the Ontario Securities Commission (OSC) has
promised to publish a proposal on imbedded fees (trailer fees) before year end. While the
OSC is still consulting with key stakeholders, Chair Maureen Jensen has publically stated
her distaste for such fee mechanisms. We fully suspect the OSC to move towards a
model where trailer fees are banned, and brokers continue to move towards a fully
transparent AUM fee model for clients. While such fee models are already on the rise in
the high net worth world, the discount brokers will have difficulty adopting such a model.
As such, discount dealers will be incented to either add some commission onto the
purchase of mutual funds not unlike the commission paid when transacting in ETFs or
limit their offering to in-house product. The independents will be watching closely to see
how the various dealers handle this potential loss of revenue streams.
The CSA has also put forth a proposal that would allow hedge funds to offer product to a
much wider audience of retail investors. Currently such funds are only allowed to
distribute to exempt investors, who due to either their wealth, investment sophistication or
both are deemed best able to appreciate the risks such products may offer. The proposal
is aimed to give greater flexibility to investors looking to gain exposure to uncorrelated
funds, downside protection and asset classes typically not allowed within mutual funds.

The distribution of fund product is likely to be one of the more interesting spaces over the
coming year. Regulators face the uncomfortable challenge of trying to ensure the
robustness of the independent asset manager space, while continuing to move towards
more transparent fees and better investor protection. One area that is ripe for change is
the ability of mutual fund dealers to trade in mutual fund like products. Currently ETFs,
ETPs and PTFs are all regulated under the same rule set, but mutual fund dealers are
unable to transact in these products. Such restrictions will be difficult to justify if a best
interest standard is formalized. A dealer would be hard pressed to meet such a standard
if they are unable to purchase a large percentage of the available product for their clients.
To this end the merger of IIROC and the Mutual Fund Dealers Association (MFDA), and
subsequent allowing of such transactions seems inevitable.
Canadian Securities Exchange (CSE) adds Market Maker Participation
Last quarter we wrote at length about proposed auto execution facilities at both CSE and
Aequitas that allowed designated market makers greater ability to trade against retail, or
retail like, order flow without greater risk of trading against large recurring institutional
flow. Since that note, Aequitas has succumb to street pressure and withdrawn part of
their proposal, which would have set different fee schedules for latency sensitive traders
versus non latency sensitive ones. The CSE proposal is still pending regulatory approval.
The CSE has upped the ante by further proposing that Market Makers gain the ability to
auto participate on up to 40% of incoming Guaranteed Minimum Fill (GMF) eligible
orders. GMF orders are almost exclusively retail order. As such, the participation allows
for market makers to trade only when the contra side of the trade is retail, and thus less
likely to be trading the first few shares of a large order. While the TMX allows their
Registered traders the ability to participate in a similar manner, the TMX participation
trades against both MGF and non MGF eligible orders. As such the Registered Trader
(RT) is just as likely to be trading versus a larger institutional order, as a small nonrecurring retail order. Likewise, Aequitas offers their DMMs the ability to participate on
15% of the volume, but again must trade against all manner of participants.
The entire basis for creating these facilities is to enhance the expected value of each
trade for the market maker. As the market maker is better able to trade versus favorable
flow, without risk of trading against large orders, they gain the ability to consume a great
share of such active orders. This, by definition, means there is less active retail flow for
traditional institutional investors to trade against, in their attempt to build or unwind
investment positions.
Given what we view as an inevitable negative impact on Institutional clients, we are
strongly opposed to this proposal. That said, we appreciate the difficult position our
regulators are in, having allowed some forms of segmentation already. We reiterate our
view that the Canadian market needs to final decide what, if any, forms of order
segmentation are acceptable once and for all.
TMX Adding Post Only Dark Orders
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Effective November 21 , the TSX will allow fully hidden orders to be marked post only .
As such, these orders will only trade when they are the passive side of any transaction.
While post only midpoint orders are a common feature offered by equity markets around
the globe, the TSX version offers a twist that we have only ever seen from NASDAQs
Canadian CXC ATS. The twist involves the way orders change priority as a result of
changes to the protected NBBO. When a quote change results in the mid-point moving
away from a post only order, the post only doesnt trade against a non post only order on
the other side. However, when the post only moves toward the post only order type not

http://www.osc.gov.on.ca/en/Marketplaces_xxr-tsx_20160707_rfc-npc-tsx.htm

only does a trade occur, the post only becomes the passive side and gets paid a rebate.
Lets walk through a quick example, to make this easier to understand.
Stock XYZ has a protected NBBO of 10.00 10.05. Thus the midpoint is 10.025. If the
book contains a non post only hidden order to buy 5,000 shares with a 10.05 top, and a
post only full hidden order comes in to sell with a 10.00 low, no trade occurs. The two
traders are both willing to transact at the 10.025 midpoint, but the post only will only
transact if they are the passive side, and earn a rebate. As that order was entered after
the non post only, the post only would be considered active.
If the quote then moves toward the buyer say 10.00 10.04, with a midpoint of 10.02,
both players are still willing to transact, but the post only nature of the seller again
prevents the trade from occurring.
If some time later perhaps a fraction of a second the quote returns to the original
10.00 10.05, and the midpoint is once again 10.025 the market now reprices the sell
order first, because of the direction of the quote change, making it the passive side of the
trade. As such, the trade goes off at 10.025 and the latter arriving sell order earns a
rebate. This repricing mechanism protects post only orders from trading at a lower price
on a fleeting quote change, and offers them the ability to earn a passive rebate versus
orders that arrived in the book earlier. The non post only order, which is unconstrained, is
open to adverse price movements and higher exchange fees. The impact is that, once
again, the user of the post only has a small increase in the expected value of any trade,
and the liquidity seeking order pays a slightly higher rent. This incents liquidity seeking
orders to also use the post only, making midpoint matches less likely for everyone. In
contrast, fully hidden orders on the NYSE keep time priority ensuring post only orders
never take the passive side of a print versus a prior entered order.
In our extensive discussions with TSX management on this issue, it is very clear they
have spent much time considering this issue, and they do correctly note that keeping time
priority throughout the arc of the trade does bring its own set of complications. If two
contra orders are not matching because the later order is marked post only, it is possible
a new order will come in and trade versus the post only as the aggressor, while the same
side original order does not get a fill. This is actually possible even under the current set
up, but becomes more likely if time priority is kept. To us this just highlights the
complicated tradeoffs that must be made when post only orders are offered up by
any market and leads us to question the value of these order types in general.
While we dont agree with the manner in which TSX is implementing the dark post only
order type, we do give them a shout out for their transparency. Not only did their OSC
filing explain how the order type would interact with other orders, they also updated their
Order Type and Functionality Guide, as well as their Dark Liquidity Guides within 24
hours of getting regulatory approval. These guides continue to be among the best offered
by any Canadian markets, and deserve a round of applause. We strongly encourage all
Canadian venues to publish such concise and clear documents, showing pertinent
examples of how various order types actually interact so all participants can understand
the market on an equal footing.
NASDAQ Goes Dark for Halloween
st2

NASDAQ Canadas dark pool NASDAQ CXD will go live on October 31 . CXD will
offer continuous dark trading at mid-point as well as at the touch, subject to the existing
Canadian dark liquidity rules. Matching priority will be on a Price/Broker/Time basis i.e.
broker priority will exist for orders not marked anonymous. Trading in NASDAQ CXD will
be free to start, to attract initial users of the system, before switching to a yet unknown
fee model.
2

http://www.osc.gov.on.ca/en/Marketplaces_ats_20160505_rfc-change-new-dark-trading-book.htm

CXD will have post only dark order types acting exactly as the TSX post only is
described above which suggests the ultimate pricing model may be a maker / taker, or
even taker / maker model as opposed to the paypay model at MATCHNow. At present
CXD will allow the post only order type during the fee holiday. As post only is theoretically
designed to allow participants to manage venue fees, we would encourage them to
disable this feature during this period. Otherwise post only becomes solely a mechanism
to game the quote, as describe in the section above.
Given the recent rise in Canadian dark volumes, and the relatively low level of dark
trading compared to the US market, the introduction of a new dark pool makes natural
sense. The dark pool will offer NASDAQ a manner to introduce their own technology into
the Canadian market, before migrating the existing markets CXC and CX2 from the
legacy Chi-X technology.
Changes to the MOC
The TSX is making a small, but important change to their MOC facility as of November
st
21 . At that time, the TSX will start publishing a second MOC imbalance, for any stock
going into extension, at 4pm. Currently the TSX only publishes a single imbalance at
3:40pm and this will remain the case for the vast majority of cases when the stock does
not go into extension i.e. is going to move 10% from the last tick or final 20 minute
vwap.
In the event a second imbalance is required, participants will be able to send contra side
orders into the auction to mute volatility. While the number of stocks going into
extensions has declined significantly since the January 2015 introduction of all day limit
on close orders, this small change should further reduce volatility on major index days,
and improve the efficiency of the MOC facility.
Order Protection Rule Update
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As of October 3 , 3 lit venues lost their protected status due to a lack of continuous
trading market share. Aequitas Lit, Lynx and CSE are now all unprotected markets. The
very early data suggests all have lost some market share due to the loss of protection,
but it is still too early to tell how this has impacted the quality of fills on these venues.
If the venues have lost passive orders in the book, without losing router priority on active
orders, the change may actually represent an opportunity to gain queue priority by
posting on these venues. If instead they have lost active flow then the expected value of
orders posted on these venues will be lessened. We suspect the results may differ by
venue. Readers can expect a more data intensive update on this in the coming weeks.
Aequitas to List More ETFs
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On September 13 , Blackrock Canada announced their intention to migrate a number

existing ETFs from TSX to Aequitas. When migrated, these funds will join PowerShares
DWA Global Momentum Index ETF on the Aequitas platform. Given BATS success in the
ETF listing space, one can certainly appreciate Aequitas strategy in pushing to list such
products.

CDS and CDCC Integration

On their Q2 Earnings call, TMX Group announced that they will be integrating their equity
clearing house (CDS) with their derivative clearing facility (CDCC). The integration should
create significant cost savings for the TMX. Less clear is whether the integration will allow
them to offer up cross asset margining, that should lead to efficiencies for options and
ETF market makers (among others).
If such margining is allowed, the TMX will need to make clear whether they would also be
willing to work with other clearing houses to offer similar cross asset savings. For
example, if NASDAQ Canada were to create an options market that utilized some other
clearing mechanism (OCC?), would they be able to compete on equal terms with the
Montreal Exchange in terms of margin requirements?
MatchNow to Offer Free Internalization
ITGs MatchNow Dark Pool will cease charging brokers on trades where they are on both
st
sides of the transaction, effective November 1 . Internalization will be free regardless of
whether either or both sides of the trade are marked anonymous.
CANADIAN MARKET SHARE TRENDS
Canadian trading volumes remained light in the third quarter, despite a relatively hot
market in metals and mining stocks.
Canadian Market Volumes

Source: ITG Canada

900

Volume (Million Shares)

800
700
600
500
400
300
200
100
-

We did witness a sharp decline in bid ask spread, back to late 2014 levels, accompanied
by an increase in posted size at the NBBO.

Canadian Market Average Spread

Source: ITG Canada

20

Percentage Spread (Bps)

18
16
14
12
10
8
6
4
2
0

Canadian Market Average at the NBBO

Source: ITG Canada

140,000
120,000
100,000
80,000
60,000
40,000
20,000
Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

Jan-16

Block Trading saw modest increases over the second quarter. Overall block share
continues to hover right around the 15% of volume mark

Canadian Market Block Trading Share

Source: ITG Canada

Overall trading costs, as measured by our peer database, are down sharply from the first
quarter of 2016.
Canadian Market Average Trading Costs

Source: ITG

140

120

Performance (bps)

100

80

60

40

20

Realized Costs

ONE LAST THOUGHT

As we studied the various marketplace uses of Post Only order types, we produced a
chart that left us both concerned and confused. The chart below illustrates the
percentage of orders on various venues that are cancelled or altered in less than 1
millisecond (ms).
Ultra-Fleeting Orders by Trading Venue

Source: ITG Canada

The dark pink line at the top of the chart is Alpha. Roughly 15% of passive resting orders
in Alpha are cancelled or altered within 1 ms. This is notable as passive orders that arent
marked Post Only, are subject to a random speedbump of at least 1 ms. As such, only
Post Only orders should be able to cancel this quickly, and any active order reacting to
one of these fleeting orders has zero chance of trading with the order, due to the
speedbump. We understand some diminished level of ultra-fleeting orders but 15%
seems significant. The level of fleeting orders is 50% higher than the next highest
marketplace TSX.
Now to be fair to TSX, due to both the speed of their trading engine, and the sizable
number of high speed players collocated in their facility, we would expect them to have
the highest levels of ultra-fleeting quotes. But for any market to have 15% of quotes last
for less time than it takes a new active order to enter the book begs the question what are
these strategies trying to do? And what is the value of these untransactable quotes? We
again question the true value of post only orders that are used for more than managing
venue trading fees.

METHODOLOGY NOTES
Large Cap is defined as total capitalization greater than $5 billion CAD, Mid Cap
is defined as capitalization greater than or equal to $500 million and less than $5
billion CAD. Small cap is defined as capitalization less than $500 million CAD.
Unless otherwise noted, we look at TSX-listed securities on all venues on which
they trade in Canada. We exclude debentures, rights, warrants, and preferred
shares as well as $US tickers (*.U) and when measuring statistics such as bid
ask spreads and volatility, we exclude stocks priced under $1.
We define blocks as single trades of 10,000 shares or more with at least
$100,000 in value. Upstairs blocks are identified as broker to broker crosses,
excluding after hours trading and trades done during futures expiry (Must be
Filled (MBF) sessions). Downstairs blocks include trades between two different
brokers and anonymous crosses as well as dark trading.
In measuring blocks we do not consider the following trades to be blocks: trades
on market on close, MBF trades, extended hours trading, and ETF trading.
When measuring blocks we include stocks <$1.
Expected Costs are based on ITGs Agency Cost Estimator (ACE), estimated
cost for a 5% MDV order executed with a VWAP strategy and a single-day
horizon, and are dollar volume-weighted across the universe of symbols.
Peer Group performance is based on arrival price (Implementation Shortfall) and
includes all trades executed in symbols with price > $1, order shares greater than
2000, and not more than one day to completion.

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DISCLAIMERS
The opinions expressed herein are those of the writer and do not necessarily reflect the opinions of ITG Canada
Corp. This report has been prepared solely for informational purposes only and is not intended to provide
financial, legal, accounting or tax advice and should not be relied upon in that regard. Information provided in
this report is believed to be accurate and reliable, but we cannot guarantee it is accurate or complete or current
at all times and no representation is made in this regard. Conclusions and opinions do not guarantee any future
event or performance. ITG Canada Corp. is not liable for any errors or omissions in the information or for any
loss or damage suffered. Although the information contained in this report has been obtained from sources that
ITG Canada Corp. believes to be reliable, we do not guarantee its accuracy, and as such, the information may
be incomplete or condensed. All opinions, estimates and other information included in this report constitute our
judgment as of the date hereof and are subject to change without notice. ITG Canada Corp. will furnish upon
request publicly available information on which this report is based. ITG Canada Corp. is a member of
Investment Industry Regulatory Organization of Canada (IIROC) and the Canadian Investment Protection Fund
(CIPF). The information herein is believed to be accurate at the time of publication, but the information is
subject to change without notice. ITG Canada Corp. is also affiliated with the Canadian equity marketplace
SM
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MATCHNow . MATCHNow is a product offering of TriAct Canada Marketplace LP (TriAct), member CIPF
and IIROC.
These materials 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. No guarantee or warranty is made as to the
reasonableness of the assumptions or the accuracy of the models or market data used by ITG Canada Corp. or
the actual results that may be achieved. ITG Canada Corp. 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. All information, terms, and pricing set forth herein is indicative and
based on, inter alia, market conditions at the time of this writing and are subject to change without notice.
2016 Investment Technology Group, Inc. All rights reserved. Not to be reproduced or retransmitted without
permission. #71916-9543
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ITG Canada wholly owns Triact, which runs a Canadian Dark ATS called MATCHNow . ITG Canada has a
minority ownership in, and a Board Seat on, Aequitas Innovations Inc. which operates Canadian marketplaces
which may be discussed in this article.
Broker-dealer products and services are offered by: in the U.S., ITG Inc., member FINRA, SIPC; in Canada,
ITG Canada Corp., member Canadian Investor Protection Fund (CIPF) and Investment Industry Regulatory
Organization of Canada (IIROC); in Europe, Investment Technology Group Limited, registered in Ireland No.
283940 (ITGL) (the registered office of ITGL is Block A, Georges Quay, Dublin 2, Ireland). ITGL is authorized
and regulated by the Central Bank of Ireland; in Asia, ITG Hong Kong Limited (SFC License No. AHD810), ITG
Singapore Pte Limited (CMS License No. 100138-1), and ITG Australia Limited (AFS License No. 219582). All
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of the above entities are subsidiaries of Investment Technology Group, Inc. MATCHNow is a product offering
of TriAct Canada Marketplace LP (TriAct), member CIPF and IIROC. TriAct is a wholly owned subsidiary of
ITG Canada Corp.
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