Completing the Circuit: Canadian Regulation

Wendy Rudd of the Investment Industry Regulatory Organization of Canada (IIROC) describes the Canadian approach to circuit breakers, minimum size and increment requirements and the role of dark liquidity.
What is currently driving the regulatory policy agenda with regard to circuit breakers?
Globally, and Canada is no exception, we have seen the introduction of new rules in several areas related to the mitigation of volatility. Circuit breakers are just one of those areas. While some reforms may have been in the works already, the Flash Crash of May 2010 certainly served as a catalyst for a broader debate about market structure, trading activity and the reliability and stability of our equity trading venues.
Volatility is inevitable, so when does it become a regulatory concern?
From our perspective – and we regulate all trading activity on Canada’s three equity exchanges and eight alternative trading systems – we see it as a priority to mitigate the kind of shortterm volatility that interrupts a fair and orderly market. We do not expect to handle this role alone; it is a shared responsibility that includes appropriate order handling by industry participants and consistent volatility controls at the exchange/ATS level.
What are the benefits of harmonizing circuit breaker rules with US markets?
One main advantage to a shared or complementary approach is that it limits the potential for certain kinds of regulatory arbitrage in markets that operate in the same time zone. Many Canadian-listed stocks also trade in the US, and roughly half of the dollar value traded in those shares takes place on US markets each day.
Which approaches are you considering taking for market-wide circuit breakers?
We are monitoring developments in the US, where regulators have proposed changes which include lower trigger thresholds calculated daily, using the S&P 500 (instead of the Dow Jones Industrial Average) and shorter pauses when those thresholds are triggered. We are currently exploring options for marketwide circuit breakers which include continuing our existing policy of harmonizing with the US, pursuing a ‘made-in-Canada’ alternative or identifying a hybrid approach that does a little bit of both. At this stage, we are soliciting industry feedback on the merits of these three approaches. With the help of that feedback, we expect to be able to choose the appropriate path soon. It is important to note that these kinds of circuit breakers are an important control but have traditionally acted more as insurance – they have only been tripped once in the US and Canada since being introduced in 1988.
How similar is IIROC’s new Single-Stock Circuit Breaker (SSCB) rule to the US rules?
Single-stock circuit breakers are relatively new for both jurisdictions. The US and Canada have implemented SSCBs which are similar in that a five-minute halt is triggered when a stock swings 10% within a five-minute period. Otherwise, the Canadian approach differs in several ways. For example, our SSCB does not trigger on a large swing in price if a stock were trading on widely disseminated news after a formal regulatory halt.
Do you believe circuit breakers, market-wide or single-stock, have a deterrent effect on momentum trading?
We did not set out with a prescriptive approach to influence or change trading behaviour or strategy. IIROC’s circuit breaker policies were developed to provide added insurance against extraordinary short-term volatility. We intend to study the impact of any changes and we may be able to learn more about the impact of policy changes on trading behaviour.
How would you characterize the response to the minimum size and minimum increment rules for dark pools?
As expected there is a range of strong opinion about any efforts to regulate an emerging area of market structure like dark pools and dark orders. We have consulted extensively with the industry in Canada towards developing a policy proposal, including a series of one-on-ones with individual parties who commented. A common concern was that the dark market had not evolved far enough in Canada to warrant the kind of policy development we have pursued. We wanted to be proactive and to put the kind of regulatory standards in place that would protect market integrity while maintaining competitive capital markets.
What is your greatest concern about unlit trading venues?
I would say our biggest challenge (related to the growth of dark liquidity) is to ensure that we are able to maintain robust and meaningful price discovery and improvement in Canadian markets. We need to balance the need for fair and equal access to liquidity for all investors, while recognizing the role that dark pools play in facilitating the execution of large (for example, institutional) orders.
What other issues on your Canadian policy agenda have been keeping you busy?
Well, related to volatility, there have been several initiatives aside from circuit breakers. We proactively educated the industry and investors on the use of order types – especially stop losses without limits – in today’s high-speed, multiple-marketplace environment. We have started working with the marketplaces toward harmonization of their volatility controls. And we are increasing transparency to our policies and procedures on breaking or re-pricing erroneous and unreasonable trades, in part through the implementation of our SSCB policy.
What else is on the agenda for the coming year?
Like FINRA in the US, we also regulate investment dealers and their activity, but I will restrict my comments to market regulation. We expect to be able to announce an important policy update relating to short sales very soon. Last year, after conducting several studies of  market activity, we proposed rule changes that would include a repeal of the ‘tick test’ restriction that prohibited a short sale from being made at a lower price than the last sale price of that security.
We always balance our policy reforms against consistency with global regulatory approaches. That said, this is an example where we recommended a ‘Made in Canada’ policy, based on our empirical research which found the tick test was ineffective as a tool to restrict significant and rapid systemic declines in prices. Our studies saw no correlation between short sales and a high failure rate for trades. We have bolstered other areas relating to shorts. These include increasing settlement rigor through rule changes, heightening surveillance of settlement failure, as well as monitoring for correlations between an increase in short selling activity and downward price movements. We are also working towards increasing public transparency of short sales with new reports.
Another area we are actively analyzing is high-frequency trading (HFT). It is a subject where there are many opinions but still too few hard facts. We are conducting a study to better understand the characteristics of this type of activity and its effects on markets generally, and to develop a stronger set of data to assist us in identifying issues as well as assessing their impact.
How does technology assist you in the analysis of trading?
Just a day before the Flash Crash, we started running our Surveillance Technology Enhancement Program (STEP) and we are pleased to say it passed the test. Canadian regulation has the advantage of having a single regulator (IIROC) administering a single set of market rules (UMIR) on all exchanges and ATSs. STEP cements that edge by offering a consolidated, cross-market view of all trading activity. This is invaluable not only in terms of real-time surveillance and building custom alerts but in creating a rich set of data for post-market analysis. Finally – your readers will be interested to know that Canadian marketplaces connect to STEP using FIX to optimize messaging flexibility.