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CNQ Comments — Provisions Respecting Competitive Marketplaces

Canadian Trading and Quotation System Inc. (“CNQ”) appreciates this opportunity to respond to the above-noted request for comments contained in Market Regulation Services Inc.’s (“RS”) Market Integrity Notice 2006-019. While CNQ generally supports the proposed amendments to the Universal Market Integrity Rules to accommodate trading of securities in multiple marketplaces, we are concerned that the proposed amendment to the in-house client priority rule is unworkable and may prove a barrier to competition.

CNQ is a recognized stock exchange in <?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />Ontario, the first new marketplace to be so recognized since the adoption of the national marketplace rules in 2001. Earlier this year, CNQ obtained Ontario Securities Commission approval to operate the Pure Trading Facility, an alternative marketplace to trade securities listed on other Canadian marketplaces. Pure Trading is currently operating as a cross reporting facility, but it will shortly offer a full, visible electronic auction market that directly competes with the other exchanges.

Although the request for comments purports to introduce a new exception to the in-house client priority rule (UMIR rule 5.3) for customer instructions that an order be entered on a particular marketplace, it implicitly provides a new interpretation of the application of that rule that we do not believe was intended when the original rule was first drafted. This new interpretation is that a dealer must reallocate non-client fills to client orders entered previously on other marketplaces.

This will prove unworkable. Dealers rely on a marketplace’s allocation algorithm to ensure compliance. Both the Pure Trading facility and the other exchanges will reallocate the non-client side of an intentional cross to any client orders of the firm in the Book at that price. Dealers do not have internal systems to monitor non-client fills and do reallocations, and it will be time-consuming and expensive to build such systems. The only way a dealer will be able to ensure compliance with the rule is to direct all of its order flow, both pro and client, to a single marketplace. This does not foster the goal of increased competition and will thwart the development of new marketplaces.

We share RS’s concern that dealers not be able to intentionally take trading opportunities from their clients. However, we believe that the interpretation is overbroad and not necessary to ensure investor protection.

The current client priority rule is based on the rule adopted by the Toronto Stock Exchange to accommodate price/time priority, where pro orders in the queue ahead of client orders would be filled first. Previously, the rule required the firm to give all client orders in-house priority at a given price; while this was feasible in a floor-based trading environment, it was not in an automated one. When the amended rule was adopted, it was not the intent to extend it to create “universal” time priority for client orders; there were concerns that this could be seen as the TSX attempting to require orders to be entered on its market rather than on the Montreal Exchange.[1]

The original premise of the rule was that a client’s consent to a pro order receiving a fill as a result of a system allocation could be implied provided the dealer did not withhold the client order other than in a bona fide attempt to get better execution.[2] Therefore, if the client order was entered directly on a marketplace, a dealer could rely on a system’s allocation, no matter the marketplace on which the order was entered. We believe this should still be the case.

Our recommendation is consistent with the existing provisions that allow a non-client order to trade ahead of a withheld client order provided the trader entering the non-client order has no knowledge of the client order. Similarly, if a pro trader knows of unexecuted client orders in other marketplaces, he or she should reallocate any fills to those orders. We are concerned that firms that have gone to considerable effort and expense to create information barriers to prevent their pro traders from learning details of unexecuted client orders will no longer be able to rely on these barriers.

Taking this approach that we advocate not absolve a dealer of its obligation to make a reasonable determination that a client will obtain satisfactory execution on a particular marketplace. If a dealer shows a pattern of entering client orders on markets where they are not filled and entering pro orders on markets where they are, it should be treated as a best execution violation rather than a client priority violation. Rather than focus on isolated instances where one order receives a fill ahead of an order entered earlier on another marketplace, RS should use its resources to focus on dealers that have not made reasonable order routing decisions.

We thank you for this opportunity to comment. Please direct any questions to Mark Faulkner, Director Listings & Regulation (416.572.2000 x2305, [email protected]) or Timothy Baikie, General Counsel & Corporate Secretary (416.572.2000 x2282, [email protected]).