01 IIROC’s best execution proposal
In December, IIROC published proposals that would “consolidate the best execution requirements in Universal Market Integrity Rules and Dealer Member Rulebook requirements for fair pricing of over-the-counter securities into a single dealer member rule respecting best execution.”
The proposal addresses concerns from an IIROC survey on best execution practices, incorporates feedback from a June 2015 roundtable and reflects CSA’s proposed amendments to National Instrument 23-101–Trading Rules.
Doug Clark, managing director of research at ITG Canada in Toronto, says IIROC’s proposal addresses two problems:
- Asymmetry between registered and non-registered firms
- Systematic routing of retail orders to the U.S. for cheaper execution
“There was a big difference between how small dealers were handling best execution versus large dealers, and [IIROC] wanted to level the playing field,” says Clark, explaining that small, non-registered firms trade through the correspondent desk at banks or brokerages.
“They’re not participating organizations within the TSX, and, as a result, under the old rules they were exempt. They didn’t have to worry about best execution, and it wasn’t really clear whether the broker that took their orders […] had a best execution obligation, either.”
He further points out that dealers who reduce compliance costs by giving up their IIROC registration and then using other dealers to trade—essentially becoming research-services firms—no longer have the economic incentive to do so.
The new rule ensures everyone has the same obligations.
Clark says the key issue, however, is retail firms sending bulk orders to the U.S. for cheaper execution, which affects Canadian volume and liquidity. Further, U.S. wholesalers “are buying orders not based on the best price, but based on the best end economics to the dealer. So there’s no competition at the quote level.”
The proposal explicitly states that sending client orders in bulk to a foreign market without considering Canadian and other liquidity sources is not compliant with best execution requirements. “That is seen by both Canadian and U.S. participants as a real shot across the bow,” says Clark. Canadian dealers, dependent on their retail reputations, will be forced to comply to avoid a reputational hit and non-compliance fine, he says.
Deana Djurdjevic, senior vice-president of equities trading at TMX Group in Toronto, sees the proposal as welcome guidance in an increasingly complicated marketplace. “This rule […] is much broader than just dealing with U.S. execution. […] They’re cleaning up one of the most important obligations a dealer has—the current best execution framework is […] outdated. It’s been around for a long time and was created before we had the dark pools and before we had non-protected markets and before we had this whole debate on order flow going to U.S. wholesalers.”
Clark says Canadian regulators are ahead of the curve on this issue. “It’s nice to see them making these changes without a crisis driving it. This is forward-looking stuff, which is good.”
IIROC’s deadline for comments is March 24, 2016.
02 CSA proposal on risk-rating methodology
On December 10, 2015, CSA published proposed amendments that would require a standardized risk-classification methodology for the ratings that appear on Fund Facts and, if they’re approved, the proposed ETF facts. Currently, managers have discretion on which methodology they use to determine risk level.
CSA developed the proposal with feedback received throughout the POS disclosure project, as well as from an earlier risk-rating methodology proposal published in 2013.
As in the 2013 proposal, CSA is floating standard deviation as the standard methodology.
Darin Renton, partner at Stikeman Elliott LLP in Toronto, says, “There’s real consensus around the common […] methodology,” noting comments from the 2013 proposal showed industry participants were in favour of a uniform measurement for increased comparability.
Jim Hong, a partner at Torys LLP in Toronto, notes the uniform methodology would benefit investors. “When you see two funds [rated the same], you know at least they came to that conclusion using the same methodology.”
“They’ve also extended it to ETFs,” says Renton, “which I think is helpful. ETF growth is exponential right now, and as that asset class continues to increase in size, it makes sense that investors should be able to compare them to their close cousins—mutual funds.”
Hong says using standard deviation is “the least disruptive to the market, because the vast majority of [managers] were using [it].” Because it’s so widely used, standard deviation “imposes the least amount of costs on the market. And that’s not insignificant in that [when] you impose costs on the market, those costs get indirectly borne by investors.”
Also like the 2013 proposal, 10 years’ performance would be used in calculating a fund’s standard deviation.
“It’s longer than the IFIC guidelines,” says Renton, which are based on three or five years of monthly returns. He calls the 10-year window “a long time frame” that will result in a truer picture for investors. “If you take shorter periods, there could be greater volatility between periods, which means the risk rating for a fund could change more frequently.”
Although Hong commends the proposal overall, he says there are always problems with one-size-fits-all solutions. A single risk measurement tool can’t capture all aspects of a fund, he says.
“[Standard deviation] works great for certain types of products, not so great for other[s],” he says, “because mutual funds and ETFs focus on different types of strategies.” For example, bond funds will have an increased risk profile in an environment where rates move frequently.
Renton says, under IFIC guidelines, managers had discretion to move down a risk rating. “Essentially, the new proposals are going to create a floor on risk. Based on your standard deviation, that’ll be your minimum [risk level],” he says.
However, managers will have some discretion, he says, when picking a comparable index for funds without a 10-year history. The proposal provides guidelines for picking the most appropriate index and provides flexibility to blend one or more indices.
“But if there isn’t a comparable index, or if [managers] feel for whatever reason the risk category isn’t appropriate, they have to go to the regulator for […] relief,” he says.
In contrast to the 2013 proposal, the new proposal retains IFIC’s five-category risk scale, instead of expanding it to six.
The comment period closes March 9, 2016.
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by Michelle Schriver, assistant editor of Advisor Group.