The classic definition of “fair market value” – the price a willing buyer would pay a willing seller if neither were under any compulsion to buy or sell – is deceptively simple and hence widely appealing. In securities trading, however, the simplicity and elegance of this definition come at a cost, namely that they don’t take into account a long list of factors that directly affect trading prices in securities. To name just a few, information available to market participants, the interaction of different market places, the regulation of market participants versus markets themselves, the participation of automated trading systems in the market place, market automation and technology and constant increases in order execution speeds all have real impacts on both the actual results experienced by participants in securities trading as well as the perceptions of those participants of market fairness, integrity and other intangibles.
While there has for some time been a consensus in Canada as to the characteristics of an efficient and effective market at a theoretical or macro level, the “devil is in the detail” in that market regulation must constantly adjust to the commercial and technological changes in the markets themselves. As restated recently by the Canadian Securities Administrators (CSA)1, the five basic concepts that underpin market efficiency and effectiveness are:
- liquidity
- visibility and transparency
- price discovery
- fairness
- integrity
In recent months, after consultation and extensive analysis for a period of almost five years, some significant changes have been made by the CSA to both National Instrument 21-101 Market Place Operation and National Instrument 23-101, Trading Rules. While many of the changes are highly technical and arcane to all but those involved day to day in market mechanics, two of these changes have been broadly debated and go not only to the root of the five market efficiency and effectiveness principles but also to the philosophy and theory of markets generally.
Billed by the CSA as the “key part of the Amendments”1 is a new Order Protection Rule (the Rule) that will supersede the Investment Industry Regulatory Organization of Canada (IIROC) Best Price Rule. The Rule consists of a framework that requires, as a marketplace obligation, all visible, immediately accessible, better priced limit orders to be filled before other limit orders at inferior prices, regardless of the marketplace where the order is entered. The Rule requires all market participants – whether exchange members or alternative trading systems – to fill these orders and in so doing creates an incentive for investors to contribute to the price discovery process. Without the incentive of assured execution under the Rule, investors may become reluctant to disclose their intentions as they would otherwise not benefit from making disclosure and disclosure in itself operates to assist other investors in making trading decisions. Without the Rule, therefore, the regulators believe that investors may lose confidence that their orders are being fairly treated. This negative perception of the market place will of course in time mean that such market place loses investors and trading volume.
The Rule will take effect in February 2011. Until then the IIROC Best Price Rule continues to apply. Without attempting to fully describe the many technical aspects of the new Rule, it should noted that the existing Best Price Rule does not apply to all participants and that it effectively requires best efforts only in terms of price differentials in different markets: it does not contemplate market participants routing orders simultaneously to more than one marketplace.
The other significant change the CSA has made is to prohibit the intentional locking or crossing of markets. The CSA defines a locked market as two orders on the opposite side of the market, e.g. a bid and an offer in two different markets, at the same price. Locking is resolved either by additional orders in either of the markets involved or the migration of one of the orders to the other market. Crossing is where a bid order on one marketplace is higher than an offer order on another marketplace or vice versa. Crosses are usually resolved quickly by arbitrageurs.
The critical limit on the new prohibition is “intention”. Unintentional creation of a locked or crossed market is not caught by the new prohibition which became effective in January 2010. Some market theorists consider that this rule is too restrictive, i.e. mere intention should not sufficient to create a breach of trading protocol. The CSA decided however that they wanted a rule that was consistent with investor, particularly retail investor, expectations and so opted for intention without qualification.
While the CSA does acknowledge the argument that locking the market “represents the most efficient market by eliminating the bid-ask spread”1, the chief negatives of locking are investor confusion at the failure of displayed orders to be executed and the associated perception of lack of market integrity.
In making their choices on these two significant amendments was well as the many more minor ones, the CSA has been guided not only by what they believe is required to assure fairness but also perceptions of fairness by market participants of all kinds. The changes support both and thus avoid damage to Canadian markets that could have arisen from loss of confidence in market fairness and the other necessary qualities of an efficient and effective market.
1 Ontario Securities Commission, “History of 21-101 – Marketplace Operation, Companion Policy, Forms 21-101F1, 21-101F2, 21-101F3 and 21-101F4“. Ontario Securities Commission, “History of 23-101 – Trading Rules and Companion Policy 23-101CP”
