Re: IIROC Rules Notices Proposed Amendments to the Definition of Basis Order

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1 Kevin McCoy, Director, Market Regulation Policy, Investment Industry Regulatory Organization of Canada, Suite King Street West, Toronto, Ontario, M5H 3T9 June 20, 2014 Re: IIROC Rules Notices Proposed Amendments to the Definition of Basis Order Dear Mr. McCoy, Scotia Capital Inc. (Scotiabank) appreciates the opportunity to comment on the above-noted Rules Notices. We are strongly supportive of the proposed amendments to the Basis Order rules with respect to the developing marketplace trends in ETFs. We believe that for the most part they take a reasonable and practical approach in replacing the current set of legacy rules that govern this area. We do, however, feel that in many instances even this expanded definition of Basis Trade does not go far enough in reflecting the realities and practicalities of ETF trading and best execution thereof, and we will further expand on some of these cases below. In particular, we feel that the component securities requirement, as defined, is far too narrow to encompass the broad styles of ETF which have been developed and currently trade in the Canadian marketplace. Comment on Basis Order Question 1 The current definition of Basis Order requires that the component securities weighting of the executed derivative are comprised of at least 80% listed securities. Is it appropriate that the Proposed Amendments consider component securities other than listed securities (e.g. securities traded on foreign and OTC markets)? We are very supportive of the change of language in the definition of basis order to encompass current and past market practice, and the original intent of the framers of the rules. In particular the specific inclusion of ETFs assists with the clarity of the definition. However, since the time that these rules were initially created to target a very specific type of transaction (Index Participation Units), there have been many developments and creations in the Canadian ETF marketplace which it would be appropriate to address at this time. No longer is an ETF a simple portfolio of component Index Stocks all trading in the Canadian Marketplace. Now, portfolios may contain both domestic and foreign: stocks, bonds, loans, OTC derivative contracts, other ETFs, foreign currency hedges, commodities, commodity futures, listed or OTC options, and more. They may be leveraged positively or negatively. They may have portfolios that are only loosely related to the basket of securities required to create or redeem them. Each of these

2 elements blurs the meaning of what types of components are appropriate as bases for trading against. Thus, we strongly agree, despite the opaqueness of certain marketplaces, that basis trading against all forms of component securities is appropriate. That said, we feel conflicted about the issue of intra-dealer asset trading which might mask inappropriate execution details from clients with whom basis trades are occurring. The chain of best execution duty may be broken or obscured. We feel, however, that these issues should be dealt with via appropriate disclosure to and consent with clients participating in such trades. Question 2 Similar to the existing definition, the Proposed Amendments require that the executions of the component securities represent at least 80% of the component securities weighting of the underlying interest of the derivative instrument or the ETF. Is 80% an appropriate measure? We understand the strict wording of this requirement to include the following items: 1 The trading of the actual component securities of the ETF, 2 In a proportion such that the traded value of each component security is at least 80% of the security weighting implied by the deconstruction of the ETF. Both of these elements raise some practical concerns. Actual component securities Firstly, we find the requirement that a security be an actual component of an ETF to be inflexible and insufficiently broad in the context of the current Canadian ETF landscape. We will illustrate with some examples: 1. Similar ETFs: One ETF (ETF1) may track the exact same underlying asset return as another ETF (ETF2). We feel that is appropriate to allow basis trading between ETFs which decompose into, or may be converted into, the same, or substantially similar, underlying securities. This is despite the fact the security being basis traded is not the component security itself. 2. Similar Assets: One ETF (ETF3) may contain a component security which has returns materially similar to another asset. For instance, spot silver and silver futures. We feel that where the proposed basis security has returns which are substantially similar to (or convertible into) the component security, that basis trading should be allowed. 3. ETFs as components: One ETF (ETF4) may contain another ETF (ETF5) as one of its components. This is particularly common where a US product is being tracked (e.g. XSP). We feel that it is appropriate to allow basis trading where the components of ETF5 have been traded (rather than just ETF5 itself). We do not feel that mandating trading in ETF5 as a component is desirable.

3 4. Creation/Redemption basket subset (Bond Funds): The creation or redemption basket of an ETF may be a small subset of the component securities of the ETF. This is particularly true of bond ETFs where the basket may contain 10 bonds, but the fund may contain hundreds. Thus, meeting an 80% component weighting test under certain definitions of the test would be impossible or impractical. 5. Derivatives: An ETF (ETF6) may contain an asset or index-linked derivative as one of its components. In this instance, the ETF returns may be perfectly tracked with the asset or index components (or other derivatives), even though these items are not components of the ETF. We feel that basis trading of these types should also be allowed. 6. Leverage: An ETF (ETF7) may have returns which are positively or negatively leveraged to the performance of an index, asset or basket of assets. Such ETFs are usually created with embedded derivative contracts. There is a formulaic relationship between the underlying and the Net Asset Value of the ETF. We feel that basis trading of such securities is feasible and should be permitted. The underlying issue in each of these cases is one of tracking or correlation. We suggest three main considerations for dealing with non-identical components: 1. Convertibility/Exchangeablity: We feel that if the components of an ETF are ultimately convertible into or exchangeable for the assets of an ETF that there is a reasonable ground upon which to allow basis trading. Some examples of securities which might be convertible or exchangeable into one another include: ETFs in continuous distribution, listed Futures contracts, listed Option contracts, convertible bonds, installment securities, and other securities exchangeable into the components in question. 2. Decomposition: Index tracking securities (e.g. Index Futures) have returns which are derived from the returns of an underlying asset. We feel that where a security is Index (or asset price) tracking that trading the underlying index securities as a hedge for the Index tracking security should be allowed. Because such securities may be unusually leveraged to the underlying, such leverage should be accounted for in return tracking by comparing notional amounts after applying leverage. 3. Return Correlation: Another option, which might be considered, is a looser, correlationbased test. Such a test might require a stable 90% return correlation between the two portfolios upon which the basis trade is intended. The Montreal Exchange uses a modified form of this test in its requirements for Exchange for Risk trading. To quote: baskets must be reasonably correlated to the underlying index with a correlation coefficient (R) of.90 or more. Furthermore, these stock baskets must represent a weight of at least 50% of the underlying index or must include at least 50% of the securities of the underlying index. The notional value of the basket must be fairly equal to the value of

4 the futures contract component of the exchange transaction. Exchange traded funds are also acceptable, provided they mirror the index futures contract against which the EFP transaction is made. As one can see, the elements of convertibility, decomposition and correlation are all suggested in the Montreal Exchange requirements. In fact, only the final element has enough flexibility to allow basis trading of bond fund products. The trading of all of the components of many bond fund products is neither practical nor possible. Therefore, bond products may be the most difficult type of exemption to deal with, as they will almost certainly require an imperfect hedge. At least 80% test We feel that the issue with component weighting is concerned with how closely the economic performance of the hedge securities tracks the ETF in question. Thus, it is the residual difference between the portfolios that should be of concern to the test, and not the absolute amount of the hedge. For instance, 200% of the implied hedge amount is at least 80%, but the residual difference between the two portfolios is large. Thus, we feel the focus of the test should be on the residual difference between the decomposed ETF and the decomposed hedge, if there is to be a test of this nature. Our second concern surrounds the nature of board lot rounding where component amounts are small. We feel that ignoring residual amounts caused by board lot rounding is appropriate. Question 3 - Should Basis Orders for units of ETFs which are actively managed be excluded from the definition of Basis Order? It is our opinion that, subject to concerns related to portfolio rebalancing amounts, actively managed funds should be basis tradable. One suggestion might be to allow such trading only on funds which change component weightings by less than a certain percentage on a day (e.g. 10%). This restriction would ensure that ETF performance tracking closely matches that of the proposed hedge, since ETF changes would be de-minimus on a daily basis. Question 4 - Should Basis Orders for units of ETFs be limited to include only ETFs that track the performance of a particular index? We feel that the answer to this question is no, for two main reasons: Firstly, the general purpose of basis trading is to allow a participant to deliver the best pricing and best tracking on an ETF by accessing all of the liquidity available in like products such as the underlying components. The goals of basis trading a liquid index (such as the SPTSX60) of

5 stocks versus an ETF are no more valid than those trading an ETF on an unfollowed index or asset. In fact, they may be less valid, as all of the liquidity in the ETF may only exist in the underlying securities themselves. Denying counterparties the overall liquidity of the portfolio by restricting the trading of the ETF in this way seems counterproductive to the goals of market liquidity and transparency. When an investor can allow a dealer to access the best liquidity possible for the execution of their ETF transaction, the whole market wins. Secondly, since an index can be any normalized portfolio of assets whose returns are tracked throughout time (subject to rebalancing due to defined events), if trading is restricted to well known or approved indices, it is our opinion that this will grant economic benefit to the index provider(s) so chosen, and blesses that index with special trading and benchmarking status. We think this is unnecessary and undesirable. Concluding Remarks Given our concerns regarding the wording of the definition of basis order, but recognizing the difficulty in drafting alternative language, we felt that it would be appropriate to suggest alternative language for discussion purposes. Our suggestion focusses on the first two cases of component similarity described above, because we feel that a correlation-based test would be subject to too much complexity in drafting and interpretation. Basis Order means An order for the purchase or sale of a derivative instrument that is a listed or quoted security, or an Exempt Exchange Traded Fund (the Target Security ) which will be executed at a price determined in a manner acceptable to a Market Regulator that is based on the price or prices actually achieved by the participating organization responsible for the basis order, on the execution, on that trading day, of securities (the Hedge Securities ) which comprise, or which through their terms are convertible into, exchangeable for, or derive their value directly from the components (the Underlying Components ) of the underlying interest of the Target Security. The Residual Value of the Hedge Securities shall be no more than 20% of the value of the Target Security. In addition, Residual Value means the sum of the component by component difference, any difference being positive, between the dollar value of the Hedge Securities component as compared with the

6 implied Target Security component. Residual Value due to rounding for standardized trading unit may be ignored. As always, we appreciate the opportunity to respond to the proposed amendments and guidance, and would be pleased to discuss any of our comments or provide more information. Yours Sincerely, Myran Faust Managing Director, Equity Related Products Global Equity, Global Banking and Markets Scotia Capital Inc. (416) cc: Susan Greenglass Director, Market Regulation Ontario Securities Commission Suite 1903, Box 55, 20 Queen St W Toronto, Ontario, M5H 3S8 marketregulation@osc.gov.on.ca