Securities regulators launch consultation on internalization

The consultation asks stakeholders to consider how the trading practice fits in the evolving Canadian market

Securities regulators launch consultation on internalization

The Canadian Securities Administrators (CSA), along with the Investment Industry Regulatory Organization of Canada (IIROC), have announced the publication of the Joint CSA/IIROC Consultation Paper 23-406 Internalization within the Canadian Equity Market.

“We are seeking feedback to consider how current trading practices fit within our rule framework, offer investors protection, and support the evolution and functioning of a fair and efficient market," said Louis Morisset, CSA chair and president and CEO of the Autorité des marchés financiers.

As a basis for definition, the paper considered a trade as “internalized” if it is executed with one dealer as both the buyer and the seller. A dealer may act as an agent on both sides of an internalized trade; alternatively, the dealer may act as principal in taking the other side of a client order.

The paper broke down internalized trades within the marketplace into two broad groups: those that occur deliberately through an “intentional cross,” and those that happen through an “unintentional cross” on a marketplace as a result of trade-matching priority methodologies. The paper noted that the Canadian rule framework does not allow internalization that arises from order execution by a dealer unless the execution occurs on a marketplace.

“[Through intentional internalization], dealers may benefit from increased efficiencies, greater trading revenue and potentially achieve better outcomes for their clients,” the paper said. “However, as technology and trading strategies continue to evolve, we have heard concerns regarding a perceived increase in the magnitude of dealer internalization on Canadian equity marketplaces, and the potential impact of any such increase on the quality of the Canadian market.”

An important element of the concerns is broker preferencing, a common order-matching feature in many Canadian equity marketplaces. The feature allows an incoming order sent to a marketplace to match and trade first with other orders coming from the same dealer, even ahead of orders from other dealers at the same price that have time priority. That feature, according to the paper, may contribute to internalization may occur through unintentional crosses.

Based on data covering January 2016 to June 2018, the paper found that unintentional crosses accounted for 13.91% of trading activity by number of trades, 12.75% by volume, and 13.4% by value. Intentional crosses, meanwhile, composed 0.11% of activity by number of trades, 8.87% by volume, and 11.67% by value.

The paper discussed numerous key issues and considerations from internalization, including:

  • The common versus individual good;
  • The impact of broker preferencing in an evolving Canadian market;
  • How advanced dealer systems that leverage technology may intersect with the definition of a marketplace (and the corresponding requirements) in the Canadian rule framework; and
  • The retail investor and segmentation of retail orders

The window for commenting is open until May 13. Stakeholders may find the CSA notice and the full paper on CSA member websites.


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