New Rules Proposed for Direct Electronic Linkages to Exchanges and Other Marketplaces
Under Canadian securities law, registered dealers are intended to intermediate orders between customers and marketplaces. Sophisticated marketplace participants maintain a variety of relationships with brokers, some of whom are expected to provide order-routing services rather than advice. These sophisticated participants generate large volumes of orders to buy and sell securities and are concerned with limiting costs and delays in conveying orders to organized marketplaces. Accordingly, accessing marketplaces by direct electronic access (DEA) allows sophisticated marketplace participants, such as institutional traders, to effect their complex trading strategies more efficiently.
For many years, institutional traders could get DEA without being locally registered or complying with particularly intrusive rules. In recent years, the trading practices of these institutional traders have led to trading interruptions or crashes that have prompted study by regulators. As a result of this increased scrutiny and after years of relatively loose regulation in the area, Canadian securities regulators are now proposing a comprehensive new regulatory framework for electronic trading and DEA effective March 1, 2013. The new framework introduces restrictions on the provision and use of DEA and two other forms of third-party electronic access known as "routing arrangements" and "order execution services".
Who may provide and use DEA under the new framework?
Under the new framework, DEA can only be provided by investment dealers that are marketplace participants (e.g., members of a stock exchange or subscribers to an "alternative trading system" marketplace) to portfolio managers, restricted portfolio managers or certain limited classes of non-registrants (typically sophisticated individual investors).
DEA is accomplished when a client uses the participant dealer’s marketplace participant identifier (MPID) for the purpose of electronically sending orders to a marketplace either directly or by using the participant dealer’s system for automated onward transmission. A participant dealer is responsible for all trading activity that occurs under its MPID, whether it is trading for its own account, for a customer, or is providing DEA.
Exempt market dealers – another category of registered person in Canada – are not permitted to use DEA. However, if an exempt market dealer is also registered as a portfolio manager or restricted portfolio manager, it can enter into DEA arrangements in that capacity.
Generally, a DEA client may only trade for its own account, but may trade using DEA for the accounts of its clients if it is registered as a portfolio manager, restricted portfolio manager or in an analogous category in a foreign jurisdiction that is a signatory to the IOSCO Multilateral Memorandum of Understanding. In these limited permitted circumstances, the orders for the other person must flow through the DEA client’s systems before being entered on a marketplace. This is to ensure that DEA orders are subject to reasonable risk management and supervisory controls.
Key DEA requirements under the new framework
Under the new DEA proposals, a provider of DEA must:
- set minimum standards for DEA clients to ensure the client has:
- sufficient financial resources to meet any financial obligations that may result from the use of DEA by that client;
- reasonable knowledge of and proficiency in the use of the order entry system;
- knowledge of and the ability to comply with all applicable marketplace and regulatory requirements; and
- reasonable arrangements to monitor the entry of orders through DEA;
- confirm at least annually with each DEA client as to whether the client continues to meet the minimum standards set out above;
- have a written agreement with each DEA client that specifies that:
- the DEA client will comply with marketplace and regulatory requirements, as well as with product limits and credit or other financial limits specified by the participant
- the DEA client will take all reasonable steps to prevent unauthorized access to the technology that facilitates the DEA and will fully cooperate with marketplaces or regulation services providers in connection with any DEA-related investigation or proceeding;
- the DEA client will immediately inform the participant dealer if it fails or expects not to meet the standards set by the participant dealer;
- when the DEA client is trading for the accounts of its clients, the DEA client will take all reasonable steps to ensure that its client orders will flow through the systems of the DEA client;
- the DEA client will inform the participant dealer in writing of all individuals acting on the DEA client’s behalf that it has authorized to use its DEA client identifier; and
- the participant dealer has the authority, without prior notice, to reject, vary, correct or cancel orders and discontinue accepting orders;
- be satisfied that the DEA client has sufficient market, regulatory and operational knowledge and require the DEA client to get additional training if necessary; and
- assign to the client a unique "DEA client identifier" which the client must use on all DEA orders.
Under the new framework, a participant dealer that provides electronic access to a marketplace to an investment dealer or foreign dealer equivalent under a routing arrangement must:
- establish standards to manage the attendant risks;
- enter into written agreements with each investment dealer or foreign dealer equivalent to which the participant dealer will provide access;
- establish and apply appropriate supervisory and compliance procedures for orders entered under the routing arrangement;
- at least annually review the standards and compliance of each investment dealer or foreign dealer equivalent with the standards and written agreement; and
- establish procedures for reporting to IIROC non-compliance by an investment dealer or foreign dealer equivalent with the standards or written agreement.
Order execution services
Participants that provide order execution services that are not accompanied by investment advice (sometimes referred to as "discount brokerage services" or "execution only" services) must:
- restrict the use of such accounts to retail customers (i.e., non-institutional customers) and review client accounts on an on-going basis to ensure continued client eligibility;
- exclude the use of such accounts by "high order volume" clients (no specific order volume thresholds have been established at this time); and
- exclude the use of automated order systems (other than those provided by the participant dealer) and confirm at least annually client compliance in this regard.
Comments on the DEA proposals may be submitted until January 23, 2013.