Three Canadian market watchdogs are joining forces to scrutinize a recent rise in “internalization” of equity trading flow by large banks and dealers.
The aim is to determine whether these transactions, in which the same dealer is on both sides of the trade, disadvantage any market participants, and whether regulatory intervention is required.
There has been no suggestion that any rules are being broken, and industry sources say the regulators stepped in after growing concerns among some market players came to a head in a confrontational exchange at a conference in Toronto’s financial district last month.
According to two accounts of what transpired at the Nov. 2 conference, an exchange between a speaker from RBC Capital Markets and an official from a proprietary trading and market-making firm turned heated when the latter suggested that big banks are intentionally keeping trades within their walls at the expense of others in the market.
“Concerns among certain stakeholders” were acknowledged this week by staff of the Investment Industry Organization of Canada (IIROC) and the Canadian Securities Administrators, an umbrella group for provincial securities watchdogs, and the regulators said they are committed to digging into whether any rules need to be changed.
“In light of these concerns, and our own concerns, we are gathering information in order to understand current practices and how these activities fit into our current rule framework in order to determine what, if any, action is required to ensure that the Canadian market is not negatively impacted,” the regulators said in a joint statement.
TMX Group, the owner of the Toronto Stock Exchange, is also getting involved, and plans to hold an industry roundtable Jan. 23. Among the questions the exchange owner wants answered is whether internalized order flow provides benefits or causes harm, and to whom.
The rise of broker internalization of retail trade order flows was dubbed the “biggest story” in Canadian equity trading in a September article published in consultant Tabb Group’s Tabb Forum.
“The level of dealer trading that is the same dealer on both sides, matching on market, has grown significantly over the past few quarters,” wrote author Doug Clark, who is head of research at ITG Canada.
The percentage of orders matched by the same dealer rose by more than 10 per cent over six months, he wrote, noting that the top five internalizing firms matched themselves more than 6.5 million times on TSX-listed issuers in a single quarter.
Clark said his analysis of the data showed no evidence of anyone breaking the rules.
“Instead, we find a growing number of dealers using a variety of mechanisms to better increase the odds of trading with themselves in the market,” he wrote.
These include routing orders to venues where the dealer already has resting orders, using market-maker incentives in a sophisticated manner, and aggressively quoting names the firm is most active in. Some of the dealer behaviour suggests they are able to “anticipate slightly larger orders about to cross the spread and join the bid,” but all mechanisms used appear to adhere to rules around order exposure and systemic internalization, Clark said.
Still, he said it makes sense for regulators and practitioners to come together to determine whether there should be limits to internalization, particularly since some of the measures were put in place in an unsuccessful bid to keep trading flow on inter-listed stocks in Canada.
Andreas Park, an associate professor of finance at the University of Toronto, said the questions being asked by regulators should reveal key data on the specifics and scope of the various mechanisms used to internalize trade flow. This, in turn, can be used to measure the impact of internalization on everything from trading, to price discovery, to market function.
“This is a data question: To what extent does it happen… and what’s the harm?” said Park, who is on a committee that advises the Ontario Securities Commission on market structure.
“Just because it happened doesn’t (necessarily) mean that someone’s harmed.”
He noted that much of Canada’s financial regulation is principles based, which means the assessment is likely to consider not only whether practices breach the rules, but also whether they challenge the spirit and intention of those rules.