On October 25, 2012, the Investment Industry Regulatory Organization of Canada (IIROC) released proposed amendments (the IIROC Proposed DEA Amendments) to its Universal Market Integrity Rules (UMIR) and Dealer Member Rules (DMR) intended to provide a comprehensive framework to regulate various forms of third-party electronic access to marketplaces provided through Canadian investment dealers. The IIROC Proposed DEA Amendments are meant to complement the proposed amendments to National Instrument 23- 103 – Electronic Trading (NI 23-103) announced by the Canadian Securities Administrators (CSA) on the same day (the CSA Access Proposals, and together with the IIROC Proposed DEA Amendments, the Proposed DEA Amendments).
The 2011 Proposal
As discussed in a previous Blakes Bulletin, NI 23-103 was initially proposed in April 2011 (the 2011 Proposal) to address various risks of electronic trading and impose risk management and supervisory controls, policies and procedures on marketplace participants with respect to all electronic trading including Direct Electronic Access (DEA). However, provisions respecting DEA were not included in the final version of the instrument which was published on June 28, 2012 and will become effective March 1, 2013. Instead, such access provisions were deferred and are now incorporated into the CSA Access Proposals. Provisions relating to DEA and other forms of DEA (i.e., order routing arrangements and order execution services) are also included in the IIROC Proposed DEA Amendments.
Under the Proposed DEA Amendments, participants (meaning investment dealers that are also members of an exchange, users of a quotation and trade reporting system or subscribers of an ATS) are required to:
- establish standards to manage the attendant risks relating to DEA,
- enter into a written agreement with each DEA client,
- establish and apply appropriate supervisory and compliance procedures for orders entered, including assigning each DEA client a unique identifier,
- review at least annually the standards and compliance of each client with the standards and written agreement, and
- establish procedures for reporting clients’ noncompliance to IIROC.
Direct Electronic Access
The 2011 Proposal introduced “direct electronic access” as new terminology to replace the more commonly known “direct market access” or “dealer sponsored access”. The Proposed DEA Amendments provide further clarification on the scope of DEA and confirm that access to a marketplace is a “closed system” in that each means by which an order may be entered on a marketplace must be subject to appropriate regulatory oversight, and that participants are the primary gatekeepers to electronic access to marketplaces.
Any electronic transmission of a client’s order containing a participant’s identifier to a marketplace, whether or not the order is transmitted through the systems of the participant, will be the responsibility of the participant, and, in particular, the order will remain subject to the risk management and supervisory controls, policies and procedures that the participant must adopt under UMIR.
A DEA order thus includes an order generated by an automated order system (or black box) used by a DEA client as long as the order is transmitted using the participant’s identifier, even if the participant’s filters or smart order routers vary the destination of the order for regulatory purposes.
The CSA Access Proposals do not generally apply to dealer-to-dealer order routing. The IIROC Proposed DEA Amendments divide DEA into three types: DEA for clients, order routing arrangements with other dealers (including foreign equivalent dealers) and order execution services, with a separate regime for each type.
Provision of DEA
Under this new framework, a participant may offer DEA to a broader range of clients but the participant must ensure that DEA is suitable for the client. A new suitability exemption is provided in the proposed amendment to DMR as long as the participant does not provide any recommendation to any retail customers that have been provided with DEA.
The CSA Access Proposals eliminate the use of an “eligible client list” under the current market practice, but participants may only provide DEA services to non-registrants under Canadian securities legislation or registrants who are registered as portfolio managers or restricted portfolio managers.
The 2011 Proposal allowed DEA to be provided to other participant dealers but not to restricted portfolio managers.
The rules relating to dealer-to-dealer order routing are dealt with in the IIROC Proposed DEA Amendments to UMIR under “routing arrangements”. This is a significant change from the 2011 Proposal and the CSA are seeking specific comments on this change.
Restricted portfolio manager is now added as a new category of registrant who is entitled to use DEA, as the CSA consider the risks of providing DEA to a restricted portfolio manager or a portfolio manager to be similar.
Under the Proposed DEA Amendments, DEA clients are only allowed to trade for their own account, that is, DEA clients cannot “sub-delegate” their DEA access, unless the DEA client is itself a registered portfolio manager or a similar foreign entity (i.e., portfolio manager, not broker) under specified IOSCO jurisdictions.
Exempt Market Dealers cannot use DEA
Under the Proposed DEA Amendments, exempt market dealers (EMDs) will not be permitted to use DEA. This provision remains unchanged from the 2011 Proposal even though the majority of comments received were not supportive of the prohibition. The CSA maintain the view that EMDs should be subject to UMIR if they trade securities listed on an exchange in foreign or Canadian markets. As mentioned in our July 2012 Blakes Bulletin, IIROC Notice 12-0217 has proposed that firms registered as EMDs that are conducting brokerage activities may become registered at some unspecified future time as Restricted Investment Dealer member firms.
This, however, will not prevent an EMD from trading – it only prevents EMDs from trading using DEA. If a firm is registered as both a portfolio manager and an EMD, it would be eligible for DEA provided that it only uses DEA when acting in its capacity as a portfolio manager and not in its capacity as an EMD. If this firm uses DEA to place trades for its non-advisory clients, then IIROC would consider it to be using DEA in its capacity as an EMD and therefore to be inappropriately using DEA. Similarly, if a foreign dealer is registered as an EMD, it would still be eligible for DEA provided that it only uses DEA when acting in its capacity as a foreign dealer and not in its capacity as an EMD for Canadian clients.
Other Forms of Third -Party Electronic Access
The IIROC Proposed DEA Amendments go beyond the provisions in the CSA Access Proposals and address two other identified arrangements for electronic access to marketplaces provided by a participant, namely “routing arrangements” and “order execution services”.
Under a routing arrangement, a participant permits another participant, an investment dealer or a foreign dealer equivalent (defined as a person registered in a category analogous to that of an investment dealer in a foreign jurisdiction that is a signatory to the IOSCO Multilateral Memorandum of Understanding) to electronically transmit an order relating to a security under the participant’s identifier, regardless of whether the order was first transmitted through the systems of the participant. Currently an investment dealer who is not a participant is not subject to UMIR. The IIROC Proposed DEA Amendments to UMIR would expand the definition of “participant” to include investment dealers in routing arrangements who are authorized to set or adjust on behalf of the executing participant the various risk controls, policies and procedures affecting such orders. Such new “participants” would then be subject to UMIR with IIROC oversight. Any orders transmitted through a routing arrangement are also subject to risk management and supervisory controls, policies and procedures established by the executing participant including automated controls to examine each order before entry on a marketplace.
Order Execution Services
Order execution services are provided by a participant whereby the participant accepts and executes orders from customers for trades that the participant has not recommended and for which the participant takes no responsibility as to the appropriateness or suitability of the trades to the customers’ financial situation, investment knowledge, investment objectives and risk tolerance.
The IIROC Proposed DEA Amendments to DMR provide that order execution services may only be offered to retail customers who are not allowed to use their own automated order system to generate orders, nor to manually send orders to the participant that exceed the threshold on the number of orders as set by IIROC from time to time. A “threshold on the number of orders” is not intended to be set at this time; however, IIROC seeks to reserve the authority to do so in the event order volumes associated with order execution services may pose risks to market integrity.