September 06, 2011

During the first half of 2011, it was easy to sense that the Canadian dark pool market was beginning to take off and resemble that of the United States, where off-exchange trading accounts for more than a tenth of all equity trading volume.

Global agency broker Instinet exported a pair of dark pools to Canada in May, while Goldman Sachs applied with the nation's regulators to bring its Sigma X dark pool north of the border. Meanwhile, Credit Suisse had been expected to launch the Crossfinder dark pool in Canada at some point this year. Even Alpha Group, Canada's largest trading platform, got in on the act with the May launch of IntraSpread, a dark pool aimed at leveling the playing field between retail and institutional investors.

But Canadian regulators -- which are staunchly in favor of maintaining equal access and transparency for its investors -- are leery of infecting their nation with the rampant fragmentation affecting the U.S. marketplace. Dark pools, which also are common in Europe, are a controversial topic in Canada since there's concern they could ultimately distort the prices listed on public exchanges, industry sources say.

A Chilly Regulatory Reception

Because of this, the fledgling sector doesn't have much room for growth in Canada over the next five years, according to Renee Colyer, the chief executive of global market research consulting firm Forefactor. "Some people have the perception that the dark market sort of got away from U.S. regulators," Colyer says. "The pendulum has swung quite far the other way in Canada, making it restrictive to operate a dark market in this environment."

In August Canadian regulators imposed a new regulatory framework that aims to balance the value that dark liquidity provides to institutional traders with safeguards for retail investors and pre-trade price discovery for all market participants. Under the new guidelines, visible orders must be executed before dark orders at the same price within the same market. Additionally, the Investment Industry Regulatory Organization of Canada (IIROC) will establish a minimum size threshold for dark orders.

"The proposed framework will ensure that small orders that trade with dark liquidity obtain meaningful price improvement over liquidity offered in the transparent marketplaces," IIROC chief executive Susan Wolburgh Jenah said in a statement. "At the same time, institutional traders with large orders will continue to manage their market impact costs through use of dark orders and dark pools."

Instinet Canada Cross (ICX) says the regulatory changes won't have much of an impact on the dark pools it launched earlier this year. The ICX VWAP Cross dark pool, which has been used in the U.S. for the past eight years, is designed to enable users to buy securities at the stock's consolidated volume-weighted average price (VWAP). It locks in orders shortly before the market opens, then, once the VWAP is calculated after the close, ICX VWAP Cross executes the trade at that price. The liquidity pool is built to help traders ensure that they've executed their block trades at VWAP, against which they're frequently benchmarked. The second Instinet dark pool, BLX, builds block trades by accumulating orders until a certain threshold is reached, and then prices them at the midpoint.

Since the IIROC and the Canadian Securities Administrators (CSA) are exempting VWAP from any of the proposed rules changes to the market, Instinet's VWAP Cross dark pool will be unaffected. "We always kind of knew the direction the regulators were going in, and that was partly one reason why we went with BLX and VWAP Cross as opposed to CBX, which in the U.S. is our largest dark pool," says Peter Coffey, managing director of Instinet Canada Cross. "So VWAP's good to go, and with BLX, only if they imposed a minimum size on the order would we have to make a change, and it wouldn't be a big change. The whole concept of BLX ... fits well with where the regulators are going."

But the Instinet dark pools are niche additions to the marketplace and are unlikely to be duplicated on a wide scale, according to Alison Crosthwait, Instinet's director of global trading research. "I can easily see dark pool trade volume in Canada doubling over the next five years, but that still doesn't make it very high," Crosthwait explains. "Assuming Canada goes in the direction it's going, that will curb to a certain extent the development of dark pool trading."

Competing With the 'Upstairs Market'

Regulation isn't the only thing that may impede the growth of Canadian dark pools. In 2010 dark pool trading accounted for less than 3 percent of the total Canadian market, according to a Forefactor report, "Dark Pools in Canada -- Is There Room for Growth?"

Despite its limited size, the dark market in Canada, Forefactor argued, already may be saturated due to the nation's well-entrenched "upstairs market," in which traders communicate with each other directly to negotiate trade prices. Such trades, which are inherently dark in the sense that they are not open to the public, already account for about 20 percent of Canada's total trading volume, according to an estimate by Forefactor.

But that market actually is shrinking, Forefactor's Colyer points out. "If you can pull the upstairs trading being done right now, which is actually dark -- no one has access to it -- downstairs into the dark market, then there's an opportunity," she explains. "But I'm not sure the Canadian market necessarily lends itself right now to that kind of behavior."

Algos Light Up the Dark

The growth of the Canadian dark pool sector also may be limited due to the "advent of algorithms that enable 'slicing and dicing' of block orders, making market impact less of an issue," Forefactor's report added. According to Colyer, Forefactor suspects these algorithms, which are growing in popularity because they allow traders to buy and sell large orders of stock without tipping off the market, are a culprit behind the diminishing upstairs market.

"The adoption of algorithmic trading has been pretty rapid," Colyer says. "Canada is really coming into its own with respect to technology. We believe algorithmic trading, excluding high-frequency trading, accounts for approximately 40 percent of the market."

Another factor that could limit the expansion of dark pools in Canada is the fact that the country generally is home to much smaller companies than are based in the U.S., Colyer adds. "It's very difficult to get those companies traded if we don't have access to an upstairs market," she explains. "So I don't know that the dark pool liquidity number will go up very quickly. If it does, I wouldn't anticipate it hitting much more than 5 percent."

A high-ranking official at a global agency broker counters, however, that while it may be hard to build a dark pool from scratch, bulge-bracket firms that possess the technology to pull it off can -- and will -- tweak their dark pools for the Canadian market. "I don't think you're going to see exponential dark pool growth," according to the source, who spoke on the condition of anonymity. "But I think you'll see Goldman, maybe Credit Suisse and Morgan Stanley offer their dark pools or something slightly different from what people are doing."

ABOUT THE AUTHOR
As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced ...