TORONTO--Canada is debating tighter border security--for stock
trades.
The country's regulators are probing dealers" practice of
routing stock orders to U.S. trading venues in exchange for
rebates, circumventing domestic markets.
The payments are legal in the U.S., albeit controversial, and
add up to hundreds of millions of dollars a year. But, in Canada,
brokers are prohibited from paying them, and regulators there,
including the Ontario Securities Commission, are exploring whether
rule changes are needed to keep more trading within the country,
said Susan Greenglass, the commission's director for market
regulation.
The scrutiny is linked to a contentious issue in U.S. markets:
payments that some companies, known as wholesalers, make to retail
brokerages in exchange for sending them orders. Some
critics--including Intercontinental Exchange Inc., the owner of the
New York Stock Exchange--have complained that the system doesn't
benefit all investors and hurts the ability for the markets to make
prices.
Proponents say the practice helps match buyers and sellers,
provides needed liquidity to the markets and makes trades cheaper
for individual investors.
In Canada, dealers have traditionally directed at least some of
their individual-investor orders to U.S. broker-dealers for stocks
that are listed on both the Toronto Stock Exchange and a U.S.
exchange or other trading platform. Of the 1,500 companies listed
on the Toronto Stock Exchange, about 200 are also listed in the
U.S.
As Canadian dealers face pressure to cut costs, the appeal of
the American rebates stands to increase.
From investors" perspective, it may make little difference
whether a trade is executed in Canada or the U.S., as long as they
get the best available price.
The Ontario commission's concern "is about the longer-term
impact on the [Canadian] market if order flow is routed to the U.S.
on a broad basis," Ms. Greenglass said. The Investment Industry
Regulatory Organization of Canada, the country's main stock-market
watchdog, said it shares this concern.
Moves by the brokerage arms of Bank of Nova Scotia, Bank of
Montreal, Canadian Imperial Bank of Commerce, Royal Bank of Canada,
Toronto-Dominion Bank and others to route retail orders to the U.S.
could threaten the effectiveness of Canada's stock markets,
regulators say. Shrinking liquidity makes a stock market less
appealing, because it becomes harder and more costly for investors
to execute transactions.
RBC said it doesn't routinely route retail stock orders to U.S.
broker-dealers, and TD said it doesn't engage in the practice.
Representatives for the retail brokerage arms of Canada's other big
banks declined to comment.
TMX Group Ltd., which operates the Toronto Stock Exchange and
other exchanges, last month announced a plan to deter the diversion
of retail flow to U.S. exchanges. Among the changes, which take
effect next June, is a new model for TMX Group's Alpha trading
platform that will pay brokers a rebate for some orders. In Canada,
exchanges and trading platforms can pay for order flow, but brokers
can't.
The new Alpha model is also designed to discourage some types of
high-frequency traders--who use computer programs to rapidly buy
and sell stocks--by slowing their ability to execute orders. These
traders rely on speed to execute transactions before orders from
individual investors and others are filled. By removing that
advantage, TMX Group hopes to put high-frequency traders and other
investors on a more equal footing.
The exchange operator's goal is "to replicate the economics [in
the U.S.] so that those [Canadian] retail brokers can get quality
execution and low-cost execution in Canada," Kevan Cowan, TMX
Group's head of equities, said in an interview.
TMX Group said it couldn't quantify the retail order flow that
its Toronto Stock Exchange and junior TSX Venture Exchange are
losing to U.S. rivals, but "we are hearing from our customers that
people are already doing this and others are considering it," Mr.
Cowan said.
What is happening in the meantime amounts to "regulatory
arbitrage," with Canadian banks circumventing domestic rules to
benefit from payments in the U.S., where payment for order flow is
legal, said Dave Lauer, president of the financial-market
consultants KOR Group LLC.
U.S. retail brokerages can make hundreds of millions of dollars
a year from such payments. TD Ameritrade Holding Corp., an Omaha,
Neb.-based bank holding company whose largest shareholder is
Toronto-Dominion Bank, in 2013 received about $236 million in such
payments from wholesalers and exchanges, according to the
company.
Some of the big broker-dealers that stand to benefit from the
Canadian business are Citadel Securities, Citigroup Inc.'s
Automated Trading Desk LLC, UBS Broker Services and KCG Holdings
Inc., according to brokers and other market SHYparticipants.
TMX Group believes Canadian regulators will need to step in to
completely resolve the issue, because of differences in regulations
governing rebates for U.S. broker-dealers and Canadian brokers, Mr.
Cowan said.
Write to Ben Dummett at ben.dummett@wsj.com, Rita Trichur at
rita.trichur@wsj.com and Bradley Hope at bradley.hope@wsj.com
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