Re: IIROC Notice Proposed Guidance on Certain Manipulative and Deceptive Trading Practices ( IIROC Notice )

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1 RBC Dominion Securities Inc. P.O. Box 50 Royal Bank Plaza 200 Bay Street Toronto, Ontario M5J 2W7 Via October 15, 2012 Naomi Solomon Senior Policy Counsel, Market Regulation Policy Investment Industry Regulatory Organization of Canada Suite King Street West Toronto, ON M5H 3T9 Dear Ms. Solomon: Re: IIROC Notice Proposed Guidance on Certain Manipulative and Deceptive Trading Practices ( IIROC Notice ) This comment letter is being submitted on behalf of RBC Dominion Securities Inc. ( RBC ) in response to the requests for comments related to the IIROC Notice published on July 17, RBC supports the objective of IIROC Notice , namely, to clarify and codify trading practices that are deemed to be manipulative and deceptive in nature. We further support IIROC s decision to commission an empirical study of high frequency trading ( HFT Study ). RBC is of the view that the current structure of North America s equity markets and dominance of the maker-taker pricing model continues to negatively impact market quality and integrity. In this regard, we believe the incentive structure built around our equity markets will continue to cause problems and must be studied and addressed as well. RBC appreciates the opportunity to comment on these important topics. Market integrity, access to liquidity, and combatting predatory strategies in the marketplace have been key tenets of RBC s trading platform. We have always been of the belief that high frequency trading cannot be broadly defined and must, instead, be broken down by strategies in order to define and regulate those which may potentially be predatory, manipulative, or deceptive. In that light, we fully support IIROC s efforts to define certain manipulative and deceptive strategies in this evolving, automated market. With this in mind, we would also like to take this opportunity to expand some of these concepts beyond the definitions included in Notice

2 Phantom Liquidity While RBC agrees with the clarification of the specific strategies set forth as manipulative and deceptive in IIROC s Notice, we note that the key common underlying aspect of many of the strategies is the same orders are being entered on a marketplace for reasons other than the intention to trade. Whether referred to as layering, quote stuffing/manipulation or spoofing, the core aspect of each strategy, and the part that makes them manipulative, in our view, is the entry of an order which is not bona fide and tradeable. The practice of entering orders without an intention to trade represents the cornerstone of most manipulative and deceptive trading practices. To this end, we see the focus on the specific strategies set out in the IIROC Notice to be a variation on a theme, a theme that is already addressed by UMIR at Part 2 (f) of Policy 2.2. Rising order-to-trade ratios over the past several years have highlighted a key trend in the Canadian marketplace an increasing number of orders that are entered into the marketplace are cancelled before they can trade. Some of these cancellations represent standard trading practices in an automated and fast-paced market, however, our concern is that an increasing number of these represent orders that were never intended to trade. The entry of phantom liquidity by certain participants, including high frequency trading firms, coupled with the acquiesce of marketplaces with respect to such activity gives the appearance of increased market efficiency in the form of tighter spreads and market depth. However, on closer examination, the liquidity is very much fleeting and concentrated in names that are generally already naturally liquid. The practice of systematically entering orders only to cancel or amend those orders within milliseconds or even microseconds, in the view of RBC, amounts to manipulative and deceptive trading and is inconsistent with the principles of market integrity. Increasingly, we see that firms may only desire to trade a fraction of the liquidity that they are displaying at any given time across multiple marketplaces. However, to increase their likelihood of a fill, they oversize displayed liquidity and cancel some of those orders as they see executions on other venues. While this may be an increasingly common activity in a fragmented market, RBC s concern with this practice is that it ultimately means firms are entering orders or quotes which are, at least in part, never intended to trade. It can almost be considered a form of layering across market venues. If a firm enters bids across multiple exchanges and ATSs that cumulatively add up to 1,000 shares but only intend to execute 500 shares, those additional bids would impact the displayed buying interest in the name. Ultimately, we feel this could be considered a form of manipulation since it gives the misleading impression of more demand in a security than there actually is. Strategies that are dependent on placing a high number of orders, only to cancel large portions of those orders upon partial execution, contribute to this phenomenon of phantom liquidity and we feel should be considered within the definition of manipulative and deceptive trading practices. To that end, we would encourage IIROC to consider defining characteristics that could be used to identify phantom liquidity and some of the manipulative and deceptive trading practices laid out in Notice This could include excessive order-to-trade ratios, high rates of messaging (including high burst rates) or amendments in relation to the amount of trades. Should order-to-trade ratios remain at this level or continue to increase, the concepts of displayed volume and truly accessible liquidity will continue to diverge in the minds of market participants. We are concerned that as market participants become less confident in the liquidity on their screens market integrity is impacted and ultimately, confidence in the market as a whole. 2

3 Latency Arbitrage Along similar lines, we would also encourage IIROC to add an additional practice to the definitions laid out in Notice : latency arbitrage. Latency arbitrage, in its simplest form, is the practice of arbitraging the latency differentials that exist within the marketplace. This could include arbitraging price variations created by latency differentials between high speed direct data feeds and slower consolidated data feeds, or even arbitraging the infinitesimally small variations of time between when portions of the same order arrive at different trading venues. Regardless of the specific method, the fundamental element of this strategy is that it takes advantage of the slight differences in time that orders, quotes or trading information arrive at different places or are received by different participants. Predatory forms of this strategy involve placing bids or offers at multiple venues, then cancelling some of those bids or offers ahead of larger incoming orders. Firms employing this strategy are able to get out of the way of incoming orders due to the different amounts of time it takes for an order to arrive at venues located in various data centers. Orders arrive last at venues which are located physically farther away from the originating order. The brief difference in arrival time between multiple venues is enough time for a firm employing latency arbitrage to cancel a portion of their displayed bids or offers ahead of an incoming order s arrival. This strategy returns to the theme discussed above that a certain portion of orders within this strategy are placed with no intention of actually trading. They are simply phantom liquidity: placed and cancelled before incoming orders that represent real intention to trade are able to access them. RBC believes that this strategy is predatory and manipulative and therefore should be included within IIROC s defined manipulative and deceptive trading practices. Rebate Arbitrage RBC would further like to encourage IIROC to consider including rebate arbitrage within its list of manipulative and deceptive trading practices. Rebate arbitrage, which takes profits from the varying fee and rebate models (also known as maker-taker models) on various venues, is often considered a more benign high frequency trading strategy. It involves placing bids or offers on higher-rebate venues, executing trades and collecting rebates, and then exiting the position by removing liquidity from a venue with a lower take fee or even a rebate. The strategy simply takes advantage of the maker-taker pricing structure and generates profits from venue rebates in a virtually risk-free fashion. While this may seem harmless, RBC s concern is that bids and offers that are posted solely for the purpose of collecting a rebate do not represent true intention to trade. After a rebate-generating trade is executed, firms employing this strategy exit the resulting position as soon as possible to minimize risk. Holding periods for this strategy are inherently extremely short the entire purpose of entering an order and executing a trade in rebate arbitrage is to collect rebates offered by trading venues. We believe bids and offers placed for the sole purpose of collecting a rebate may lead to a false impression of buying or selling interest. For this reason, we believe that rebate arbitrage should be included as a potentially manipulative and deceptive trading practice. Furthermore, rebate arbitrage creates a greater degree of competition for passive fills (buying on the bid or selling on the offer) on trading venues. If there are a number of firms posting liquidity on exchange or ATS simply to garner a rebate, this creates long queues in certain securities. When there are long queues in a security and greater competition for a passive fill, firms that represent real investors buying or selling interest are forced to cross the spread (sell on the bid or buy on the offer) more often because they are not able to obtain a passive fill in a timely fashion. This is why RBC believes that firms trading solely to collect rebates may be disadvantaging true investors. 3

4 Evolution of Policies and Definitions Based on the experiences of the past several years watching the rapid expansion of automated trading technologies, the evolution of market structure, and the introduction of new participants and strategies to the Canadian marketplace, RBC would like to further encourage IIROC to allow a degree of flexibility within these definitions of manipulative and deceptive practices going forward. With every new innovation in the market, we have seen new strategies and techniques employed that allow some participants to take advantage of those changes and some participants potentially disadvantaged. As the market continues to evolve, RBC believes this list of practices should evolve as well. New strategies and practices may emerge, but the fundamental tenets of these definitions should be that orders should always represent true intention to trade and that placing orders that manipulate or exaggerate the perception of buying or selling interest are prohibited. Strategies that fall outside this framework should be considered manipulative and deceptive under UMIR at Part 2 (f) of Policy 2.2, regardless of whether they are included in the list of practices laid out in Notice Markets will evolve further, and, as they do, our regulatory framework needs a degree of flexibility to evolve along with them. Market Structure IIROC s stated view is that while market abuse may be facilitated as a result of technology, it is the abusive nature of the practice, and not the means by which the practice is conducted, that negatively impacts market integrity. RBC appreciates the distinction that IIROC draws between the intent and means by which market abuse is facilitated. However, in the current market environment where technological collaboration between marketplaces and HFTs (such as co-location) is commonplace, the line between intent and means has become significantly blurred. Venues that cater to HFTs through technology foster high order-to-trade ratios and, by extension, phantom liquidity. An HFT firm s ability to deploy some of the strategies discussed in the IIROC Notice and above is clearly enhanced (in terms of speed, scale and ability to camouflage) with the use of marketplace technology. Moreover, it seems clear that the concerns of market practitioners charged with providing best execution for investors are in how the structures of technological complexity and incentives in our markets contribute to the attractiveness of engaging in such activities by: a) Offering direct payment in the form of rebates chiefly financed, under regulatory obligation, by natural investors. b) Offering indirect incentives in the form of an ever-changing and unstable technological ecosystem provides HFTs with an opportunity to design strategies to step aside from counterparties they find unattractive and, in some cases, also trade ahead of them. c) Rendering the ability of regulatory authorities to detect and police such activities limited by the sheer volume and complexity of the datasets required as well as significant expertise gaps on the part of regulators. d) Offering cover in obscuring the means of regulators to prove intent due to the complex, distributed and automated nature of the strategies being employed. As such, while IIROC Notice represents a positive step forward, RBC would like to strongly encourage further action. In particular, the Notice does not address the systemic factors that collectively provide both the incentives (i.e. rebates) and tools (i.e. fragmentation and co-location) to tilt the 4

5 advantage to particular market constituents at the expense of others. RBC believes that the fundamental basis of a vibrant market structure have been obfuscated by market constituents that employ the aforementioned trading strategies. Defining some of those strategies is an important initial action, however, eliminating the elements of market structure that facilitate those strategies is an integral next step in ensuring market integrity and vitality. We would encourage co-ordinated action on the part of the CSA to take these important steps to restoring the needed sense of balance to Canada s equity markets. RBC appreciates the opportunity to comment on this important topic. If you have any questions or require further information, please do not hesitate to contact the undersigned. Sincerely, Stephen Bain, CFA Managing Director RBC Dominion Securities Inc. 5