RECENT TRENDS IN TRADING ACTIVITY, SHORT SALES AND FAILED TRADES

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1 RECENT TRENDS IN TRADING ACTIVITY, SHORT SALES AND FAILED TRADES For the period May 1, 2007 to September 30, 2008 Market Regulation Policy, Investment Industry Regulatory Organization of Canada, Suite 900, 145 King Street West, Toronto, Ontario. M5H 1J8 Telephone: Fax: February 2009

2 RECENT TRENDS IN TRADING ACTIVITY, SHORT SALES AND FAILED TRADES For the Period May 1, 2007 to September 30, 2008 Further Information Questions or comments regarding this study should be directed to: James E. Twiss, Vice-President, Market Regulation Policy, Investment Industry Regulatory Organization of Canada, Suite 900, 145 King Street West, Toronto, Ontario. M5H 1J8 Telephone: Fax: Acknowledgements In the preparation of this study, the Investment Industry Regulatory Organization of Canada ( IIROC ) wishes to acknowledge the assistance of the Canadian Depository for Securities Limited ( CDS ) in providing data with respect to the value of failed trades and the number of buy-in notices handled by CDS. IIROC has also relied on trade information from each of the following marketplaces: Toronto Stock Exchange; TSX Venture Exchange; Canadian National Stock Exchange 1 ; MATCH Now; Pure Trading; Omega; and Chi-X. 1 As of November 6, 2008, Canadian Trading and Quotation System or CNQ was re-branded under its new name Canadian National Stock Exchange or CNSX. i

3 RECENT TRENDS IN TRADING ACTIVITY, SHORT SALES AND FAILED TRADES For the Period May 1, 2007 to September 30, 2008 Table of Contents List of Tables Purpose of this Report Table 1 Average Changes in Composite Index Levels Background Table 2 Average Number of Trades Per Trading Day Short Sale and Short Position Reporting Regime in Canada.. 2 Table 3 Average Volume Per Trading Day Recent Amendments to the Universal Market Integrity Rules... 4 Table 4 Average Value Per Trading Day Statistical Study of Failed Trades on Canadian Marketplaces.. 5 Table 5 Average Volume Per Trade Methodology and Data Table 6 Average Value Per Trade Summary of the Findings Table 7 Short Sales as a Percentage of Trades.. 29 Trading Activity... 9 Table 8 Short Sales as a Percentage of Volume Short Sales Table 9 Short Sales as a Percentage of Value Failed Trades Table 10 Average Volume Per Short Sale Recent Developments in the Regulation of Short Selling in Other Jurisdictions Table 11 Average Value Per Short Sale. 35 United States Table 12 Short Exempt as a Percentage of Short Sale Trades Australia Table 13 Rates of Turnover of Short Positions.. 40 United Kingdom and European Union Table 14 Rates of Short Position Reporting by Listing Marketplace Hong Kong and Asian Markets. 17 Table 15 Comparative Attributes of Short Positions Reported Analysis of Trading Activity Table 16 Monthly Changes in Short Positions Reported. 44 Market Stress.. 17 Table 17 Average Short Position and Relative Importance of Average Short Position 45 Overall Market Activity Table 18 Value of Accumulated Fails Trade Attributes.. 25 Table 19 Exercise of Buy-in Procedures 54 Analysis of Short Sales Short Selling as a Percentage of Trading Activity List of Charts Comparative Trade Attributes of Short Sales Chart 1 Closing Index Levels. 18 Short Exempt as a Proportion of Short Selling Chart 2 Volume of Average Short Sale Relative to Volume of Average Trade 33 Prevalence of Short Position Reporting Chart 3 - Value of Average Short Sale Relative to Value of Average Trade.. 36 Relationship Between Rates of Short Selling and Market Stress Chart 4 Relative Rates of Short Selling and Market Stress on the TSX.. 47 Analysis of Failed Trades.. 49 Chart 5 - Relative Rates of Short Selling and Market Stress on the TSXV. 48 Rates of Trade Failures Chart 6 Value of Accumulated Fails and as a Percentage of Overall Trade Value 52 Exercise of Buy-in Procedures Chart 7 Number of Buy-ins and as a Percentages of Trades.. 55 ii

4 RECENT TRENDS IN TRADING ACTIVITY, SHORT SALES AND FAILED TRADES For the Period May 1, 2007 to September 30, 2008 Purpose of this Study Securities regulators in Canada and abroad have recently taken regulatory action to protect investors and market integrity in light of the current and unprecedented market turmoil. To address concerns of investors and marketplace participants, the Investment Industry Regulatory Organization of Canada ( IIROC ) increased its regular monitoring of trading on equity marketplaces in Canada, including heightened surveillance of all short selling activity and rates of trade failure. IIROC has prepared this study ( Recent Trends Study ) to set out certain information with respect to recent trends in trading activity of listed securities on Canadian equity marketplaces 2 and, in particular, short selling and failed trades in the period May 1, 2007 to September 30, 2008 ( Study Period ). The analysis underpinning the Recent Trends Study and an earlier study of failed trades undertaken by Market Regulation Services Inc. ( RS, which merged with the Investment Dealers Association of Canada on June 1, 2008 to form IIROC) in 2006 (the RS Failed Trade Study 3 was used in the formulation of the recent amendments to the Universal Market Integrity Rules ( UMIR ) regarding short sales and failed trades. 4 It is expected that the two studies will inform the consideration of other proposals for the amendment of UMIR respecting short sales including: the outstanding proposal to repeal price restrictions on all short sales ( tick rule ); the outstanding proposal to replace the requirement to file short position reports with the production of summary information on short sales; and The study does not analyze the trading on markets outside of Canada of securities that are also listed on a Canadian marketplace. The study does not analyze the trading of securities over-the-counter in Canada or another jurisdiction. For a more detailed discussion of the RS Failed Trade Study and its results, see Market Policy Notice General Results of the Statistical Study of Failed Trades on Canadian Marketplaces (April 13, 2007). For particulars of the recent amendments, see IIROC Notice Rules Notice Notice of Approval UMIR Provisions Respecting Short Sales and Failed Trades (October 15, 2008). 1

5 a possible proposal to preclude additional short sales by a person who has executed an extended failed trade unless arrangements for the borrowing of the securities necessary to settle any resulting trade have been made prior to order entry ( Pre-Borrow Requirement ). 5 This information is also intended to assist in focusing discussions on whether initiatives that have been introduced or may be considered by securities regulators in foreign jurisdictions regarding short sales or failed trades would be appropriate in the context of the Canadian market. Background Short Sale and Short Position Reporting Regime in Canada The following is a brief summary of the key provisions of UMIR governing short sales and short position reporting that were in effect during the Study Period: Price Restrictions Rule 3.1 of UMIR contains the tick rule which provides that, subject to certain enumerated exceptions, a short sale may only be made at a price which is not less than the last sale price of that security on a marketplace. In September of 2007, public comment was sought on a proposal to repeal the tick rule. IIROC has been deferred consideration of this proposal because of the current market conditions and the fact that the regulatory framework governing short selling is under active review in the United States and other foreign jurisdictions. IIROC will continue to monitor developments in the Canadian market and new initiatives taken or considered by foreign regulators with respect to short sales and failed trades and determine whether further actions are warranted. The Securities and Exchange Commission ( SEC ) approved various amendments to Regulation SHO and Rule 10a-1 with an effective date of July 6, 2007 that included provisions removing all short sale price restrictions and prohibiting any self-regulatory organization (including 5 IIROC is evaluating the merits of the introduction of a Pre-Borrow Requirement that would focus any additional restrictions on the particular accounts that had executed extended failed trades rather than impose general restrictions on the dealers as is the case with the Hard T+3 Close-Out requirement adopted by the Securities and Exchange Commission in the United States as an interim final temporary rule. See SEC Release

6 any exchange) from having a price test for short sales. Effective July 6, 2007, in advance of the consideration of the publication of the proposal to repeal the tick rule, RS granted an exemption from the tick rule in respect of securities which are inter-listed between a recognized exchange in Canada (an Exchange ) and an exchange in the United States ( inter-listed securities ). This exemption ( Interlisted Exemption ) ensured that the trading of a short sale of an inter-listed security could be undertaken on a marketplace in Canada at the same price (accounting for currency exchange rates) which a short sale may have been conducted on a market in the United States. The Inter-listed Exemption will continue in force until the approval by the securities regulatory authorities or the withdrawal by IIROC from consideration of that aspect of the proposal regarding the repeal of the tick rule. Reasonable Expectation of Settlement of a Short Sale Rule 2.2 of UMIR deals with those activities which are considered to be manipulative and deceptive and, as such, prohibited. The entering of an order for the sale of a security without, at the time of entering the order, having the reasonable expectation of settling any trade that would result from the execution of the order constitutes a violation of the prohibition on manipulative and deceptive activities. The provision does not require the Participant or Access Person that is entering a short sale to have made a positive affirmation that it can borrow or otherwise obtain the securities that would be required to settle a short sale. However, once a Participant or Access Person is aware of difficulties in obtaining particular securities to make settlement of any short sale the Participant or Access Person would no longer have a reasonable expectation of being able to settle a resulting trade and therefore would not be able to enter further short sale orders. For trading in a particular security, certain Participants or Access Person who do not have the ability to borrow that security may be precluded from entering short sales while other Participants or access Person with access to borrow that security may continue to undertake additional short sales. Consolidated Short Position Reports Rule of UMIR requires each Participant and Access Person to prepare and file a short position report twice-monthly with respect to short positions in securities traded on a marketplace. The short position to be reported is calculated as the aggregate of the short positions in each account. The reports from each Participant and Access Person are then combined to produce a Consolidated Short Position Report ( CSPR ) containing the aggregate short position for each listed security together with the net change in the aggregate short position from the previous report. 3

7 Prohibition on Short Sales of Certain Inter-listed Financial Sector Issuers On September 19, 2008, the Ontario Securities Commission ( OSC ) issued an order ( Temporary Order ) prohibiting the short sale of certain financial issuers listed on the Toronto Stock Exchange ( TSX ) that are inter-listed with exchanges in the United States ( Restricted Financials ). The Temporary Order, as amended and extended, applied to trading on September 22, 2008 and remained in effect until October 8, The Temporary Order was issued by the OSC as a precautionary measure to: prevent regulatory arbitrage with respect to short selling in Ontario of the Restricted Financials as a result of initiatives by the SEC to prohibit the short sale of a broad range of financial issuers traded on markets in the United States; and promote fair and orderly markets in Ontario for trading in the securities of the Restricted Financials. The Recent Trends Study does not attempt to specifically evaluate the impact of the Temporary Order, though a number of the effects on the general trends of the prohibition on short selling of Restricted Financials are noted throughout the study. IIROC undertook a separate study evaluating the impact on trading activity of the Temporary Order ( Short Prohibition Study ). The results of the Short Prohibition Study were provided to the applicable securities regulatory authorities and were made publicly available. 6 Recent Amendments to the Universal Market Integrity Rules On October 15, 2008, the IIROC published notice of the approval by the applicable securities regulatory authorities of various amendments to UMIR dealing with various aspects of short sales and failed trades (the Amendments ). 7 The Amendments put in place various provisions which will provide IIROC with additional tools to address potential abusive short selling and failed trade activity. These provisions had previously been published for public comment in September of In particular, the Amendments: Reference should be made to IIROC Notice Administrative Notice General Impact of the Prohibition on the Short Sale of Inter-listed Financial Sector Issuers (February 4, 2009). IIROC Notice Rules Notice Notice of Approval UMIR Provisions Respecting Short Sales and Failed Trades (October 15, 2008). Market Integrity Notice Request for Comments Provisions Respecting Short Sales and Failed Trades (September 7, 2007). 4

8 require that notice be provided to a Market Regulator if, after the execution of a trade, the trade is varied (with respect to price, volume or settlement date) or cancelled; 9 provide that the Market Regulator may designate particular securities or class of securities as being ineligible for short selling; provide a definition of a failed trade and require that a report of a failed trade be made to a Market Regulator if the reason for the failure is not resolved within ten trading days following the original settlement date of the trade; 10 and clarify certain requirements that must be met for a seller to be considered the owner of securities at the time of a sale. Statistical Study of Failed Trades on Canadian Marketplaces The Amendments built on a study of failed trades undertaken by RS in The RS Failed Trade Study found that: failed trades accounted for 0.27% of the total number of trades executed; the more junior the marketplace in terms of the type of security traded, the higher the incidence of failed trades; 12 special settlement trades experienced a significantly higher rate of failure (6.15% of trades compared to 0.26% for regular settlement trades); the predominant cause of failed trades was administrative delay or error, 13 which accounted for almost 51% of fails; less than 6% of fails resulting from the sale of a security involved short sales; The requirement to provide the notice to the Market Regulator of a trade cancellation or variation in respect of which the Market Regulator has not otherwise received notice from either the marketplace executing the trade or clearing agency that is settling the trade will be implemented on or after March 1, 2009 following the development by IIROC of a web-based reporting facility for this purpose. The requirement to provide the notice to the Market Regulator of an extended failed trade will be implemented on or after March 1, 2009 following the development by IIROC of a webbased reporting facility for this purpose. For a more detailed discussion of the RS Failed Trade Study and its results, see Market Policy Notice General Results of the Statistical Study of Failed Trades on Canadian Marketplaces (April 13, 2007). Rates of trade failure for Study Participants ranged from 0.22% of total trades by Study Participants on the TSX (a total of 838 fails out of 379,211 trades), to 0.90% of trades on TSXV (resulting from 239 fails out of 26,509 trades) and 2.22% of trades on CNSX (resulting from 1 failed trade out of the 45 trades executed on CNSX by Study Participants during the Study Period). The rate of trade failure on CNSX is comparable to the 2.21% rate reported by the SEC Office of Economic Analysis for US Exchange and OTC Bulletin Board securities based on data for May of Administrative delays/errors generally include: inadvertent delays related to obtaining physical certificates for securities, custodian lacking instructions and discrepancies related to security price/amount. 5

9 fails involving short sales accounted for only 0.07% of total short sales; buy-ins were executed in only 4% of failed trades; and the average failed trade was settled 4.2 days after the expected settlement date with fully 96% of failed trades settled within 10 days after the expected settlement date. The RS Failed Trade Study was conducted in early August of 2006 and, during that time, approximately 24% of sales made by dealers participating in the study were short sales. However, the RS Failed Trade Study found that only 6% of fails resulting from the sale of a security involved a short sale. This finding is at odds with the presumption underpinning the fails list provisions in the United States which further restricts short sales when a security passes the threshold on fails and is added to the fails list. Based on the results of the RS Failed Trade Study, the Amendments require that a Participant file a report with IIROC if the failed trade is not resolved within 10 days following the settlement date and that a further report be submitted once the problem has been rectified. In this way, the specific trades which are problematic will be brought to the attention of the regulator for further review and action if appropriate. IIROC expects that one outcome of this aspect of the Amendments will be enhancements in the policies and procedures of Participants to minimize the number of trades that will be subject to these reporting requirements (the by-product of which would be a reduction in the average number of days that a failed trade remains outstanding ). Methodology and Data The analysis in this report looks at trading activity in the period May 1, 2007 to September 30, 2008 on marketplaces that retained IIROC to be their regulation services provider. The analysis includes trade information 14 from the following marketplaces: Toronto Stock Exchange ( TSX ); TSX Venture Exchange ( TSXV ); Canadian National Stock Exchange ( CNSX ); MATCH Now, 15 an ATS operated by TriAct Canada Marketplace LP; Pure Trading, 16 a facility of CNSX entitled to trade securities listed on other Exchanges; Aggregate data for overall trading activity on each marketplace is provided by the respective marketplace. Information related to short and short exempt sales is derived from the internal audit tracking systems maintained by IIROC. MATCH Now commenced trading TSX-listed securities on July 13, 2007 and commenced trading TSXV-listed securities on September 3, The Period Average for MATCH Now in this report is based on 15 months of operation. 6

10 Omega, 17 an ATS operated by Perimeter Markets Inc.; and Chi-X, 18 an ATS operated by Chi-X Canada ATS Limited. The following marketplaces have been excluded from the analysis based on the fact that during the Study Period: Bloomberg Tradebook Canada Company operated as an order router and did not execute trades in listed securities; BlockBook had a limited number of trades which precluded an ability to accurately determine trends on that marketplace; Liquidnet Canada Inc. did not permit short sales; and Shorcan ATS Limited ceased operations on May 14, During the Study Period, securities could be divided into three categories, namely securities: exempt from price restrictions on short sales throughout the Study Period, being an Exchange-traded Fund ( ETF ) traded on TSX and also eligible to be traded on MATCH Now, Pure Trading, Omega and Chi-X; exempt from price restrictions on short sales only since July 6, 2007, being inter-listed securities traded on the TSX, MATCH Now, Pure Trading, Omega and Chi-X; and subject to price restrictions on short sales throughout the Study Period, being all securities listed on TSXV and CNSX and those securities listed on the TSX other than ETFs and inter-listed securities. Attached to Market Integrity Notice Guidance Exemption of Certain Inter-Listed Securities From Price Restrictions on Short Sales (July 6, 2007) was a list of securities that, on the date of the exemption, were inter-listed between the TSX and an exchange in the United States. Similarly, RS had published a list of 32 securities that had been designated as an Exchange-traded Fund for the purposes of Pure Trading launched operation of its continuous auction trading marketplace on September 14, The list of securities eligible for trading expanded over time until the full TSX stock list was eligible for trading by February of The crossing market of Pure Trading which operated prior to the launch of continuous auction trading had a limited number of trades which precluded an ability to accurately determine trends on that marketplace. The Period Average for Pure Trading in this report, is based on 13 months of operation of the continuous auction market. Omega launched operation of its continuous auction trading marketplace on December 6, During the Study Period, Omega traded only securities exempt from the tick rule. The list of securities eligible for trading expanded over time until all of the TSX stock list was eligible for trading by October, The Period Average for Omega in this report is based on 10 months of operation. Chi-X launched operation of its continuous auction trading marketplace on February 20, The list of securities eligible for trading expanded over time until the full TSX stock list was eligible for trading by March of The Period Average for Chi-X in this report is based on 7 months of operation. 7

11 UMIR. 19 Since that time, additional securities have been recognized as an Exchange-traded Fund and other securities have become interlisted with a marketplace in the United States. However, these securities may not have the same liquidity profile and trading patterns as those securities which qualified on the date RS granted the Inter-listed Exemption. Therefore, to better establish trends in the trading of these types of securities, the classes have been frozen, for the purposes of the analysis contained in this report, as those securities which were in these categories on July 6, The results presented in this report are based on trades executed on a marketplace that have been marked either short or short exempt. While trade desk reviews conducted by RS indicate that such order markings are generally accurate, there are a number of circumstances which may have a tendency to increase the indicated prevalence of transactions involving a short sale or a short exempt sale. In particular, if an order that would be a short sale is bundled with one or more orders that are from a long position, the entire bundled order will be marked in the most restrictive manner and as such the entire volume of the order may show as having been a short sale. On an informal basis, Participants who have bundled orders are expected to provide corrected information to the Surveillance section of IIROC but this information has not been used to update the marketplace databases. Effective August 1, 2008, IIROC introduced a formal order marker correction procedure that will be used to arrive at a corrected value for bundled orders involving short and short exempt marked orders. 21 IIROC has combined information on trading activity with information on failed trades provided by CDS. CDS has made available to IIROC: for each trading day between March of 2005 and October 10, 2008: o the value of securities which are eligible for continuous net settlement through the facilities of CDS, and o the value of the cumulative net fails (outstanding trade failures that did not settle on T+3 ); and for each month in the period May 2007 to September 2008: o the number of initial failure buy-in notices received by CDS, o the number of notices changed to execution status, and For a list of the securities that had been designated by RS as an Exchange-traded Fund as of July 6, 2007, see Market Integrity Notice Guidance Designation of Additional Exchange-Traded Funds (February 28, 2007). While the analysis in this report includes 32 securities under the heading ETF, by the end of the Study Period, the number of securities which had been recognized by IIROC as an Exchange-traded Fund had increased to 73 and trading in these securities were accounting for more than 7% of the value of securities traded on the TSX in the first seven months of Trading activity in respect of these additional 41 securities is included as part of the Other securities in this report. The inclusion of the 41 securities in the Other category has the effect of overstating the average number of trades, volume and value in respect of Other securities on the TSX for the Study Period. 21 Reference should be made to IIROC Rules Notice Guidance Note New Procedures for Order Marker Correction (July 15, 2008) and IIROC Rules Notice Guidance Note User Guide for the Regulatory Marker Correction Form (July 30, 2008). 8

12 o the number of buy-ins sent by CDS to a marketplace for execution. IIROC has also combined information on trading activity with information in the period May 1, 2007 to September 30, 2008 on short positions as provided in the semi-monthly Consolidated Short Position Report ( CSPR ) as produced by the TSX. Summary of the Findings During the Study Period, there was no negative change in the pattern of short selling or trade failures. In particular, during the Study Period: Trading Activity the average number of trades per day increased significantly over the Study Period with more modest and less consistent increases in average daily volume and value; 22 the number of trades in securities listed on the TSX increased throughout the Study Period across all marketplaces trading those securities with the increase concentrated in the trading of inter-listed securities and ETFs; 23 while the number of trades in securities listed on TSXV or CNSX varied significantly throughout the Study Period, the overall trend appears to be a reduction in the total number of trades per trading day; 24 in periods of increased market stress ( Market Stress Period ) 25 trading activity as measured by number of trades and value traded exceeded the average for the Study Period 26 ; The average number of trades per trading day increased from 481,041 in May of 2007 to 925,866 trades per day in September of 2008 with an average over the period of 634,330 trades per day. With respect to average daily volume, the Study Period average was 593,076,770 with a high of 702,836,748 in October of 2007 (when volume peaked at the TSXV at 286,711,600 significantly above the Study Period average of 190,776,779) and a low of 458,400,292 in August of 2008 (when volume on the TSXV was at a low of 107,602,589). With respect to average daily value, the Study Period average was $7.67 billion with a high of $9.59 billion in September of 2008 and a low of $6.30 billion in August of The TSX averaged 591,760 trades per day over the period (from a low of 445,945 in May of 2007 to a high of 870,290 in September of 2008 with the number of trades in ETFs increasing from 3,706 per day to 15,452 and the number of trades in inter-listed securities increasing from 245,175 to 553,384). TSXV averaged 29,370 trades during the Study Period (with the number of trades declining from 34,944 in May of 2007 to 17,790 trades per day in September of 2008). CNSX averaged 111 trades per day during the Study Period (with the number of trades declining from 152 in May of 2007 to 71 trades per day in September of 2008). During the Study Period, the average daily point change in the closing index level of the S&P/TSX Composite was points, or 0.958% of the average closing index level, and points, or 1.137%, respectively, for the S&P/TSX Venture Composite Index. The average number of points (and percentage) between the average of the daily high and low index levels for the S&P/TSX Composite was points, or 1.558% of the daily average of the high/low index level, and points, or 1.556%, respectively, for the S&P/TSX Venture Composite Index. Six of the months, August of 2007 and January, March, July, August and September of 2008 experienced elevated levels of market stress across both indexes. 9

13 Short Sales there was no significant change over the Study Period in the pattern of short selling in comparison with the trading of securities generally; the granting in July of 2007 of the exemption from the tick rule for the short sale of an inter-listed security has not had any discernable effect on the pattern or attributes of short sales of inter-listed securities (other than a slight increase in the proportion of trades that are short sales); 27 in a Market Stress Period: o there is generally a lower than average level of short selling activity on TSXV, 28 o there is a slightly higher rate of short-selling on the TSX, 29 and o the average volume and value of a short sale of a security (other than an ETF) tends to be lower than the volume and value of short sales generally; 30 the more senior the security, the higher the proportion of short sales; 31 short selling activity accounts for a disproportionate level of the trading activity on the new transparent marketplaces (possibly indicating a concentration of arbitrage and algorithmic trading); The average daily number of trades in a Market Stress Period was 724,060 or approximately 14% above the overall Study Period average of 634,330 while the average value of trades in a Market Stress Period was $8.01 billion or approximately 4% above the overall Study Period average of $7.67 billion. For inter-listed securities, short sales generally accounted for between 28% and 30% of trades. With the granting of the exemption from the tick rule, the proportion of short sales in trades of inter-listed securities increased to the 30% to 33% range. This increase in the proportion of short sales was anticipated on the granting of the exemption. On the TSXV, short sales accounted for 4.1% of trades in a Market Stress Period as compared to 4.5% throughout the Study Period. On CNSX, short sales accounted for 7.3% of sales in September of 2008 significantly above the Study Period average of 4.2% of trades. However, the average for the other five months which are considered a Market Stress Period was only 3.6%. On the TSX, short sales accounted for 27.5% of trades in a Market Stress Period as compared to 26.1% of trades throughout the Study Period. During a Market Stress Period, short sales had an average volume which was generally less than the Study Period average for short sales ranging from 15% to 17% less for inter-listed and other securities on the TSX to just 3% to 5% less for securities traded on TSXV and CNSX. During a period of market stress, short sales had an average value which was generally less than the Study Period average. The differences ranged from 12% less than the Study Period average in the case of a short sale on CNSX to 20% less in the case of a short sale on TSXV. Over the Study Period, short sales of securities listed on the TSX accounted for 26.1% of trades (30.5% of inter-listed securities, 17.1% of ETFs and 19.5% of other TSX-listed securities) as compared to 4.5% of trades of TSXV-listed securities and 4.2% of trades of CNSX-listed securities. For the new marketplaces which publicly display order information, the proportion of short selling ranged from 36.7% of trades on Pure Trading, to 43.2% of trades on Chi-X and 56.3% of trades on Omega (which during the Study Period limited trading to securities which were exempt from the tick rule.) For MATCH Now, which operates as a non-transparent marketplace, short selling accounted for only 14.6% of trades. 10

14 during the Study Period: o two-thirds of issues on the TSX reported a month-end short position as compared to only a quarter of the issues on TSXV, o short positions in TSXV-listed securities turned over twice as fast as for TSX-listed securities, 33 o monthly short positions amounted to approximately 16% of trading volume in TSX-listed securities as compared to just over 1% of trading volume for securities listed on TSXV and CNSX, and o the average short position for a security represented the volume of 1,523 average trades on TSX for a TSX-listed security as compared to 18.1 average trades on TSXV for a TSXV-listed security and 2.6 average trades on CNSX for a CNSX-listed security; Failed Trades over the Study Period: o the number of failed trades as a percentage of the overall number of trades has generally been declining, 34 o on average, 5.08% of failed trades are closed out through the execution of a buy-in on a marketplace, and o the accumulated value of failed trades as a percentage of the value of trades has generally been declining; 35 and market stress did not appear to have a negative impact on the rate or value of trade failures. 36 Recent Developments in the Regulation of Short Selling in Other Jurisdictions In light of the recent market turmoil, securities regulatory authorities in foreign jurisdictions have instituted changes to their short selling regimes, including the introduction of various temporary or emergency amendments. Several of the temporary measures adopted by foreign jurisdictions respecting short sales remain in effect as of the date of this report. A number of foreign jurisdictions have indicated that in the coming months they will be considering further permanent rule amendments respecting the regulation of short sales which are The turnover rate is determined by dividing the volume of short sales during a month by the outstanding volume of short positions at the end of the month. On average over the Study Period, the short position on the TSX turned over every.76 of month as compared to.38 of a month for the TSXV and.63 of a month on CNSX. Over the Study Period, initiated buy-in notices received by CDS represented 0.27% of trades (ranging from a high of 0.38% in December of 2007 to 0.17% in September of 2008). Over the Study Period, the value of accumulated fails as a percentage of trade value was 2.08% (ranging from a high of 2.69% in May of 2007 to 1.31% in August of 2008). During the months that were identified as part of a Market Stress Period, the value of accumulated fails as a percentage of trade value was 1.83% or approximately 12% less than the overall average for the Study Period of 2.08% and the proportion of initiated buy-ins as a percentage of trades was 0.22% as compared to 0.27% for the Study Period overall. 11

15 in line with their regulatory views on short selling and their evaluation of recent market events. The following summary of short sale regimes in various foreign jurisdictions is current as of the date of this report. United States Recent and Proposed Initiatives On July 15, 2008, the SEC issued an Emergency Order Concerning Short Selling ( Emergency Order ) with respect to 19 listed securities in the United States 37. Each of the 19 securities covered by the Emergency Order is engaged in the financial services sector in the United States and at the time of the issuance of the order the securities were generally trading at a discount of 70% to 90% from the 52-week high price of the security. At the time of the Emergency Order, only one of the 19 securities was on the fails list maintained in accordance with Regulation SHO by the market centre on which the securities were listed. Notwithstanding this fact, the Emergency Order required that a short seller must have entered into an arrangement to borrow the securities required for settlement prior to the execution of the short sale. The Division of Trading and Markets of the SEC provided guidance that an arrangement to borrow requires more than a [sic] reasonable grounds to believe that the security can be borrowed. An arrangement to borrow means a bona fide agreement to borrow the security such that the security being borrowed is set aside at the time of the arrangement solely for the person requesting the security. 38 The stated rationale for the Emergency Order was set out in the preamble to the Emergency Order which stated: False rumors can lead to a loss of confidence in our markets. Such loss of confidence can lead to panic selling, which may be further exacerbated by naked short selling. As a result, the prices of securities may artificially and unnecessarily decline well below the price level that would have resulted from the normal price discovery process. If significant financial institutions are involved, this chain of events can threaten disruption of our markets. The events preceding the sale of The Bear Stearns Companies Inc. are illustrative of the market impact of rumors. During the week of March 10, 2008, rumors spread about liquidity problems at Bear Sterns, which eroded investor confidence in the firm. As Bear Stearns stock price fell, its counterparties became concerned, and a crisis of confidence occurred late in the week. In particular, counterparties to Bear Stearns were unwilling to make secured funding available to Bear Stearns on customary terms. In light of the potentially systemic consequences of a failure of Bear Sterns, the Federal Reserve took emergency action SEC Release No (July 15, 2008). SEC Division of Trading and Markets - Guidance Regarding the Commission s Emergency Order Concerning Short Selling (July 18, 2008). SEC Release No (July 15, 2008). 12

16 The Emergency Order was scheduled to terminate on July 29, 2008 but was extended until August 12, The SEC has indicated that, following the expiration of the Emergency Order, the SEC will consider further rulemaking related to short sales. SEC Chairman Christopher Cox indicated in recent public speeches that aspects of Regulation SHO will be reviewed for possible elimination, and, in particular, the reasonable grounds to believe that a security can be borrowed prong of the locate requirement. 40 The SEC has not indicated that reversal of the repeal of price restrictions on short sales is under consideration. In part, the practical problems of enforcing tick rules in a multiple marketplace environment in the context of the application of Regulation NMS were one of the considerations in the repeal of the price restrictions. From September 17 to September 21, 2008, the SEC issued a series of Emergency Orders Concerning Short Selling (the Short Sale Orders ) which, among other things: extended the Emergency Order to temporarily prohibit all short sales in the publicly traded securities of approximately 800 financial firms (namely banks, saving associations, broker-dealers, investment advisors and insurance companies) identified by the SEC or a self-regulatory organization; 41 imposed enhanced delivery requirements on sales of all equity securities, by obliging a participant of a registered clearing agency to immediately close out any fail-to-deliver position and prohibiting any further short sales by the participant until a fail-to-deliver position is closed-out or a pre-borrow is arranged for ( Hard T+3 Close-Out ); 42 expanded the definition of what constitutes a manipulative or deceptive device or contrivance to include any person that deceives a broker-dealer, participant of a registered clearing agency or purchaser about its intention or ability to deliver a security at settlement date (and such person subsequently fails to deliver the security on or before settlement date); 43 imposed additional reporting requirements on institutional money managers to, subject to specific exceptions, disclose the number and value of all short sales executed in certain securities on a weekly basis; 44 and While the Emergency Order and the extension do not provide the rationale behind the nomination of the 19 financial firms that are the subject of the order, comments by Christopher Cox, the SEC Chairman, in an op-ed piece in the Wall Street Journal on July 24, 2008 indicate that the Emergency Order was meant to apply only to financial firms that the Federal Reserve Bank had designated as eligible for access to the liquidity facilities of the Federal Reserve Bank. SEC Release No (September 18, 2008). SEC Release No (September 17, 2008). Effective October 17, 2008, the SEC adopted, in substantially the same form, the Hard T+3 Close-Out Requirement as an interim final temporary rule (See SEC Release ). Ibid. Effective October 17, 2008, the SEC adopted an antifraud rule, Rule 10b-21 under the Securities Exchange Act of 1934, aimed at short sellers (including broker-dealers acting as principal) who deceive specified persons about their intention or ability to deliver securities in time for settlement and that fail to deliver securities by settlement date. SEC Release No (September 18, 2008). 13

17 relaxed the rules on the repurchase of shares by an issuer (i.e. timing and volume conditions of issuer bids). 45 The Short Sale Orders prohibited short sales in financial firms during the period September 18, 2008 to October 8, While the SEC has moved to adopt several of the Short Sale Orders as either final or interim rules under the Securities Exchange Act of 1934, as at the date of this report, it is not known what changes, if any, will be proposed with respect to other restrictions related to short sales. IIROC Observations on the Emergency Order In the view of IIROC, the intentional spreading of false rumours to affect the price of a security is manipulation whether the intent of the false rumour is to increase or decrease the value of the security. Such an activity would constitute manipulation whether or not the person had a position in the security or a related security such as a derivative. There is no indication from the data provided in this report that there has been either a recent negative change in the pattern of short selling or trade failures in Canada. To the contrary, the rates of cumulative trade failures expressed as a percentage of overall trade value eligible for continuous net settlement at CDS have recently been declining and, based on information from each trading day between March of 2005 and October 10, 2008, actually reached a low of 1.21% on August 22, 2008 (as compared to a period average of 2.08%). Similarly, CDS has indicated that it received 34,256 initial notices of intent for buy-ins in July of 2007 and that this number increased slightly to 36,432 in July of However, due to the increase in trading activity on Canadian marketplaces over that one-year period, such notices represented 0.32% of trades in July of 2007 (or 312 trades per notice) as compared to only 0.22% of trades in July of 2008 (or 451 trades per notice). The RS Failed Trade Study undertaken by RS in 2006 found that short sales did not have a higher risk of failure than a trade from a long position (due in large part to the finding that the primary reason for trade failure was simple administrative error). 47 Monitoring by IIROC indicates that there have been no significant changes in the pattern of short selling over the last year (other than the increase in the rate of short selling of inter-listed securities that became exempt from price restrictions on short sales in July of 2007 from a range of approximately 28% to 30% of sales prior to the Interlisted Exemption to approximately 30% to 33% in the months following the grant of the exemption). The Temporary Order applied to inter-listed securities that were also covered by the Emergency Order. IIROC undertook the Short Prohibition Study evaluating the impact on trading activity of the Temporary Order. The Short Prohibition Study found that: SEC Release No (September 18, 2008). SEC Release No (October 2, 2008). In fact, the RS Failed Trade Study found that while short selling was involved in approximately 24% of trades at the time of the study, short sales were involved in only 6% of the failed trades. In part, the outcome reflects the fact that the most likely securities to be sold short are the inter-listed securities traded on the TSX while trade failures are more likely to be associated with junior securities listed on TSXV and CNSX. For a more detailed discussion of the RS Failed Trade Study, see Market Policy Notice General Results of the Statistical Study of Failed trades on Canadian Marketplaces (April 13, 2007). 14

18 while there were unusual levels of trading activity in financial sector issuers immediately preceding the issuance of the Temporary Order: o o o short sales of Restricted Financials were in line with, or less than, historic patterns and the levels of short selling for interlisted securities generally, there was no evidence of undue short selling pressure in Canadian financial sector issuers that were not inter-listed with an exchange in the United States ( Non-Restricted Financials ), and the short position in the Restricted Financials was declining and accounted for a lower percentage of the issued capital than for TSX-listed securities generally; and the issuance of the Orders: o was coincidental with significant and proportional increases in volatility for each of Restricted Financials, Non-Restricted Financials and securities generally, and o appeared to have a significant impact on market quality for trading of Restricted Financials by reducing available liquidity and increasing the price spread. The Short Prohibition Study provides additional information on short sales and short positions of Restricted Financials in the periods prior to and following the Temporary Order. The results of the Short Prohibition Study, together with the Recent Trends Study, will permit IIROC to make additional observations on whether the approach adopted in the Emergency Order is applicable in the Canadian context. Australia On September 19, 2008, the Australian Securities and Investments Commission ( ASIC ) announced a package of interim measures relating to short sales. 48 Specifically, these interim measures: prohibited naked short sales of all securities currently eligible for shorting on the Australian Securities Exchange ( ASX ); clarified that covered short sales will continue to be permitted and provided guidance on which sales will be considered covered ; and introduced a reporting requirement (through the ASX) for covered short sales that continue to be permitted. 48 ASIC Release Naked Short Selling Not Permitted and Covered Short Selling to be Disclosed (September 19, 2008). 15

19 On September 22, 2008, based in part on the actions by US and UK securities regulators, the ASIC prohibited subject to limited exceptions, all short sales (including covered short sales that were allowed under the September 19, 2008 interim amendments). At that time, the ASIC undertook to reassess and advise market participants within 30 days as to whether the short sale prohibition would be repealed, extended or modified. 49 On October 21, 2008, the ASIC announced that the ban on covered short selling for non-financial securities is extended until November 18, 2008, at which time the ASIC expects to remove the ban. The ASIC also announced that the short sale ban respecting financial stocks will continue in effect until January 27, United Kingdom and European Union On September 18, 2008, the Financial Services Authority ( FSA ) introduced new provisions which prohibit the creation of, or increase in, a net short position giving rise to an economic exposure to shares in specified financial institutions and insurers (this will include naked and covered short sales) which provisions expired on January 16, The FSA introduced new short reporting requirements that became effective on September 23, Under the new reporting regime, a person with a net short position in excess of 0.25% of the share capital in any of the financial issuers affected by the FSA short sale interim amendments is required to report such position (including any changes in such position) by the following business day. The FSA has indicated that it expects to publish its Consultation Paper on short selling in January As at the time of this report, several European Union securities regulators have adopted, or are in the process of adopting, amendments to their respective short sale regimes both on an interim and permanent basis. While the approaches taken differ from jurisdiction to jurisdiction, the common theme amongst most of the jurisdictions involves adopting measures to enhance their monitoring of short sales. For example, Austria, Greece, Spain have each adopted requirements that require a person to disclose a net short position that exceed more than 0.25% of an issuer s outstanding capital ASIC Release Covered Short Selling not Permitted (September 21, 2008). ASIC Release ASIC Extends Ban on Covered Short Selling (October 21, 2008). The ASIC has indicated that concurrent with the anticipated removal the short sale ban on nonfinancial securities, the ASIC together with the ASX will be putting in place disclosure and reporting arrangements respecting short sales. As at the time of this report the details of the additional reporting requirements is unknown. FSA Statement on Short Positions in Financial Stocks FSA Public Notice 102 (September 18, 2008). Available at Report of the Committee of European Securities Regulators ( CESR ) on Measures Recently Adopted by the CESR on Short Selling (September 22, 2008). Available at 16