IIROC Provides Guidance on Order Execution Obligations in Volatile Markets

On May 6, 2010, Canadian marketplaces experienced very unusual levels of market volatility — a "Flash Crash." Some securities dropped more than 20 per cent from their previous day’s closing price, with most of the decline occurring in a 15-minute window. Some stocks fell more than 10 per cent in less than one second, and recovered just as quickly. Less dramatic price declines in individual securities continue to occur regularly.

This increased market volatility is associated with an increase in the ratio of orders to trades and with high-frequency electronic trading driven by computerized trading algorithms. These traders have direct high-speed access to multiple marketplaces. As the activities of some of these direct access traders can be disruptive, securities regulators are proposing comprehensive rules to increase supervision of these trading practices and to curb or prohibit them when they interfere with orderly markets.

During the Flash Crash, dropping market prices caused direct-access and other clients to enter stop-loss orders (orders to sell immediately at market price). At the same time, because of the extreme volatility, previously entered buy orders of high-frequency traders were cancelled. These orders normally moderate the impact of price decreases. The sudden disappearance of buying interest at prices near the market bid worsened volatility and ultimately resulted in severe downward price pressure. It also caused trades to occur at drastically lower prices than those that prevailed at the time of order entry.

Recent guidance has been issued to Investment Industry Regulatory Organization of Canada (IIROC) members that execute orders as market participants on stock exchanges and alternative trading systems. In summary, IIROC has stressed the following principles:

  1. In volatile markets, participants are encouraged to recommend limit prices on all stop-loss orders. A limit order (an order to buy or sell a stock at a specific price or better) provides control over execution price, but may not execute in a fast-moving market.
  2. For execution-only accounts, where no advice is provided to the client, participants should still take reasonable steps to warn users on the order-entry screen when a client enters an order with a higher risk of unintended execution outcomes, such as a stop-loss order with no limit.
  3. Where multiple marketplaces are open for trading at the same time, it is expected that the participant will choose the optimal marketplace based on its regular monitoring of the different marketplaces for the quality of executions obtained for opening orders and the opening liquidity of particular securities. Participants may choose to mitigate the risk by using order-routing technology.

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