Summary of Comments: Non-SRO Electronic Trading Systems and Market Fragmentation: Concept Proposal - 22-801 - Non-SRO Electronic Trading Systems and Market Fragmentation

Concept Proposal

February 27, 1998

NOTICE OF PUBLIC FORUM TO DISCUSS
NON-SRO ELECTRONIC TRADING SYSTEMS
AND MARKET FRAGMENTATION
22 - 801
Background

On May 16,1997, the Ontario Securities Commission (the "OSC") published a Request for Comments and Notice of Forum regarding Non-SRO Electronic Trading Systems ("Request for Comments"), (1997) 20 OSCB 2565. In the Request for Comments, the OSC indicated it was seeking information from interested parties (including stock exchanges, Non-Self Regulatory Organization Electronic Trading Systems ("NETS"), brokers, dealers and investors and was intending to convene a public forum to develop an appropriate regulatory framework for the operation of NETS, and the role of the Commission in connection therewith.

The Alberta Securities Commission (the "ASC"), the British Columbia Securities Commission (the "BCSC"), Commission des valeurs mobilières du Québec (the "CVMQ"), and the Saskatchewan Securities Commission (the "SSC"), notified the OSC that they would like to hold a joint forum where representatives of their respective Commissions would be present at the proceedings and would participate in the public meeting on the same basis as OSC Commissioners. A notice requesting comments on issues raised in the Request for Comments was published by the ASC, BCSC, CVMQ, and SSC (together with the OSC, the "Commissions") was published in each of their respective jurisdictions.

Twelve parties made submissions to the Commissions and the Commissions thank them for their contributions. A summary of the comments follows this notice.

The following sets forth information regarding the public forum to be held to seek additional guidance regarding the regulation of NETS and related issues.

Date and Location of Public Forum

The public forum to discuss NETS and related issues will be held on Thursday, April 23,1998 in Toronto, in the Harry S. Bray Hearing Room, 8th Floor, 20 Queen Street West. Depending on the indications of interest regarding speaking at, and attending the forum, the location of public forum may change and further dates and places may be added. Participants will be notified of any changes.

Structure of the Public Forum

Commissioners from the ASC, BCSC, CVMQ, OSC, and SSC will conduct the public forum and may ask questions of the presenters.

Presentations

Parties interested in making oral presentations should fill out and return the attached request form (the "Request Form") indicating an interest in making a presentation. Presenters will be allotted up to 60 minutes in which to make their presentations and respond to questions from the participating Commissioners. Consideration will be given to increasing the 60 minute limitation on a case by case basis where a presenter indicates that a longer period of time is required. Presenters should ensure that sufficient time has been set aside for responding to questions from the participating Commissioners. Presenters should indicate the amount of time required and any audio-visual aids requirements on the Request Form. In allotting time, priority will be given to those parties who have responded in writing to the Request for Comments. A transcript of the proceedings will be made. Completed Request Forms must be submitted by March 27, 1998.

Confirmation of Presentation and Attendance

Those parties who have submitted a Request Form in accordance with this Notice will be provided with a confirmation of the time of their presentation and the location of the forum.

Attendance of Public

The media and any other persons interested in attending the forum as observers are requested to fill out and return the Request Form indicating their interest in attending. Completed Request Forms must be submitted by March 27, 1998.

Specific Additional Guidance is Requested

The responses to the Request for Comments provide evidence of a considerable consensus on many areas but also identify some areas where a consensus is lacking. To assist the Commissions with their policy considerations and help participants focus their presentations, a list of topics and questions is set out in this Notice. The Commissions encourage presenters to address the following issues in their presentations and to provide corresponding written submissions.

A. AREAS OF CONSENSUS

Analysis of the responses to the Request for Comments provides evidence of considerable consensus on a number of issues.

Competitive solutions reached through the operation of market forces are to be preferred over mandated solutions.

A minimum framework must be provided to which all participants are subject. That framework must be provided by, or at least blessed by, the legal authority of government.

In addressing the minimum framework that should apply to the structure of the equities market in Canada, respondents agreed that upon execution, transactions must be reported on a timely basis for processing in a way that provides useful and easy access to market information for Canadian investors.

NETS provide a desired service that should be fitted into the Canadian equities market.

By assuring a common language (meaning that transactions are denominated and conducted in Canadian currency), those bids, offers and transactions on NETS would be fitted into the Canadian market and:

a) form part of the Canadian market transparency/price discovery scheme; and,

b) be integrated into whatever is determined to be the appropriate displacement model that assures "live" bids and offers of their entitlement to trade. For example:

i) price priority/ "trade-through" protection; and,

ii) secondary priority/sharing protocol based on time of entry or size.

How would a system operate if Canadian currency is not the mandated denomination for bids, offers and transactions facilitated by NETS for Canadian accounts by Canadian intermediaries ?

B. DISCLOSURE OF POST-TRADE AND PRE-TRADE INFORMATION ARISING FROM THE OPERATION OF MARKETS

1. Timely Last Sale Reporting

All respondents proposed that transactions for Canadian accounts (through registered intermediaries) should be reported in a timely fashion, either:

a) to a consolidator of information (e.g. the Toronto Stock Exchange now functions as a consolidator for distribution of Canadian market information outside of Canada with respect to bids, offers and transactions on Canadian exchanges); or

b) to any market information vendor that wishes to have it.

The expectation would be that the equivalent of a "consolidated last sale tape" would be constructed from this data by the vendors or by a consolidator that would provide it to the vendors.

Is it necessary for the Commissions to set standards as to data protocols and timeliness of data production for this type of information, or will market forces provide an adequate response?

Should there be a formally appointed consolidator of market information? If so, what criteria should be used in selecting such a consolidator?

2. Availability of Pre-Trade Information

Most respondents held the view that "pre-trade information" concerning bids and offers that are "in the market" and available for execution should also be public information and handled in much the same way as post-trade information, i.e. provided to vendors on a timely basis.

NETS Markets: Should bids and offers placed on NETS by their subscribers(customers) be considered "bids and offers that are in the market" and therefore be provided at no cost to vendors or to a consolidator of market information? Should subscribers be able to designate which of their orders they want treated as "in the market"?

Upstairs Markets: Should bids and offers made by dealers to institutions, by institutions to dealers and by institutions through brokers to other institutions be considered to be "bids and offers that are in the market" and therefore made available at no cost to an exchange, vendors or to a consolidator of market information? By what mechanism could this be accomplished?

Must a policy on NETS information disclosure also deal with "upstairs market" disclosure? How can the Commissions develop a solution that will not significantly undermine the perceived value of the services offered by the respective service providers but which will optimize the quality and quantity of pre-trade information available to enhance price discovery in the Canadian market?

In evaluating the requirements for pre-trade disclosure, respondents should bear in mind that when order information is disclosed in a system it is virtually impossible to limit further disclosure and/or to retain confidentiality concerning such information. If it is of interest, the information quickly becomes known on dealers' and institutions' trading desks.

It appears to be a requirement in the U.S. that the size of bids and offers made by market-makers that are quoting at the best market price in NASDAQ be disclosed where the size of the bids and offers are for 9900 shares of less. It also appears that the SEC is considering extending a similar requirement to non-market-makers.

Is it reasonable in Canada to follow a similar course for all orders (including those placed by non-market-maker subscribers) in a NETS if the orders are made for a longer period than would be considered necessary to invite a potential counter party to enter into negotiation? (For example, see the fourth bulletin under #3.)

3. General Transparency Requirements

The present disclosure regime of the TSE discloses the full size of all orders that have been entered and identifies, on certain terminals (those on desks of member firms), the broker that entered the order. The TSE disclosure regime also publishes the identity of both buying and selling broker on transaction reports.

Is this the appropriate minimum standard? Should all exchanges and NETS in Canada be required to meet this disclosure standard?

Some NETS may provide less disclosure.

An order is entered in full but it may be divided into "disclosed" and "reserve" portions. When the disclosed portion is filled, it is refreshed from the reserve until the whole order is executed. The disclosed portion of other subscribers' orders at the same price have priority over the reserved amounts. Filling priority is by time of entry of the disclosed portions. The effect of the reserved portion is to dampen the market impact by not having the order fully disclosed, while allowing it to be protected against a trade-through.

No indication is given by the system as to the identity of the institution or market-maker behind any order in the order file or on transaction reports.

Orders can be entered for display to all subscribers or limited to institutions only.

Unless an order is executed immediately or entered for a specified duration, it becomes inactive after 3 minutes. It remains in the file only as an indication of past interest.

In light of the above and other types of systems such as crossing systems, please recommend what you regard as an appropriate regime of pre-trade disclosure fortraditional exchanges and for NETS. Please consider the following questions in yor response:

a) If a NETS is required to provide pre-trade disclosure, should such disclosure be:

i) the same as its customers disclose to each other;

ii) required to meet the present exchange standard; or,

iii) required to meet some other standard?

b) Should the present disclosure regime of the exchanges be maintained or should the requirement to report order size and broker identity be relaxed?

The suggestion has been made that the minimum standard of disclosure of bid and offer information need only extend to the price level that is the best bid or offer level in the respective system. Presumably, vendors will provide an inter- system montage of existing bids and offers that would be similar to what is now provided in the United States by the Consolidated Quotation System -- the National Best Bid and Offer ("NBBO").

C. INTEGRATION OF MARKETS FOR TRADING

Several respondents to the Request for Comments pointed to the selection of models proposed by the TSE Special Committee on Market Fragmentation ( the "Committee"). "Model B" envisioned that any electronic trading systems would connect to a Canadian exchange. Any orders or matched trades coming through the system would be subject to the exchange's order display and trade matching protocols. In addition, orders coming from the NETS would be subject to monitoring done by the exchange to manage timely disclosure policy, uncover insider trading and prevent manipulative practices.

Although the TSE has recommended moving forward with Model B immediately, existing NETS and PIAC (on behalf of major institutional investors) have preferred to search for an arrangement that places NETS outside the orbit of the TSE or other existing trading SRO -- the Committee's "Model C". To define a regulatory framework with such characteristics certain trading and regulatory issues must be addressed.

To staff, it appears that there are four issues to address (beyond disclosure of pre and post-trade information) in order to determine the degree of market integration that the Commissions should order. Where there is more than one market to integrate, the issues would seem to be:

a) inter-market linkage;
b) trade-through protection;
c) secondary priority; and,
d) secondary priority by size of transaction or nature of counter party.

1. Inter-market Linkages

Even though many stocks are interlisted and some actually trade actively on more than one exchange, at the present time, competing markets in Canada are not linked electronically. Present practice requires members handling an order in an interlisted stock to monitor all markets for the best execution opportunity. Most monitoring remains visual, though some electronic monitoring is being introduced.

The potential addition to the Canadian market of one or more NETS invites re-examination of market linking through automation.

Should a bid or offer in one competing market be available for a transaction with participants in other systems? That is, should Exchanges and NETS be electronically linked so that a participant in market A is able to reach into market B to effect an execution against bids or offers in market A?

How should the linkages be created and who should operate the system? For example, through exchanges or a new entity which could be independent of the Commissions or operated by the Commissions.

At least a partial precedent for such linkage has been established in the U.S. where any NASD member can use NASDAQ's Selectnet facility to transact with a bid or offer in an electronic communication network (such as Instinet).

2. Trade-through Protection

Assuming an inter-market linkage for trade execution, consideration should be given to having that linkage provide "trade-through protection". In other words, should price priority be enforced between markets? Put another way, for a trade to be valid, must it be at a price that is between the inter-market bid-ask spread?

It has been suggested that a bid or offer in a NETS is created by an order that is purely the property of the investor that entered the order. This view holds that the extent to which any information contained in the order is disclosed to others must be determined by the originator of the order. Equally, whether a bid or offer is subject to inter-system execution and on what terms (minimum fill, all or none, any part) should also be determined by the originator.

It is important to note that the choices of the order originator are limited by the variety of facilities made available by the systems that compete to offer services.

Should a NETS (or an Exchange, for that matter) that does not participate in an inter-market linkage and agree to trade-through protection for the bids and offers that have established better prices in other Canadian markets be permitted to operate in Canada? Is that an appropriate minimum standard? Again, how should such a linkage be set up and who should operate it?

Should the choice of whether an order participates in inter-market transparency and order linkages be left to investors or should it depend on some objective criteria such as the size of the order?

3. Secondary Priority

If the competing market systems are linked, is it advisable to adopt some form of secondary priority protocol for declared bids and offers in the market at the same price whereby one side of a proposed cross may be "displaced" in whole or part by such prior orders?

Displacement entitlements, based on a secondary priority protocol, are intended to encourage investors to enter limit orders in order to compete to be the priority bidder or offeror. The theoretical work of market-microstructure specialists predicts that such competition will lead to narrow spreads and more robust order books and greater liquidity.

Discussions of displacement and secondary priority raise the issue of "quote matching" -- a practice whereby brokers with a matching buyer and seller can make a "cross" at the same price as the best bid or offer in the market. Even though shares have traded at the same price, the order posting the best bid or offer does not trade1.

There are diverse views on this subject. Some hold that the practice of quote matching is unfair to the bidders and offerors who "make the market" and moreover, that it discourages investors and professional market makers from competing aggressively and even from bothering to enter orders.

Others hold that allowing crosses to be executed at previous bid or offer prices is an appropriate reward for the broker that either searched out a counter party or provided the other side of the cross from his own inventory as principal. They note that putting together a large cross frequently involves significant work on the part of a broker. They submit that the block market is unique and that large trades should not be interfered with by relatively small amounts that are typically bid or offered in the market at the best bid or offer price. They see preferred treatment for crosses as providing liquidity and that the expeditious provision of "immediacy", in the case of a principal trade, is a service that justifies any reduction in the attractiveness of participation in an Order Book by limit order traders.

In addition, those who favour quote matching point out that an exchange or NETS has very limited ability to enforce secondary priority against proposed crosses, when a broker can simply move a proposed cross to a competing market where either quote matching is allowed, there is no pre-existing bid/offer at the same price or non-standard trading prices are offered.

In the context of inter-market linking and integration, is it necessary for the Commissions to take a position on secondary priority and displacement?

4. Secondary Priority Limited by Size of Transaction or Nature of Counter Party

As noted above, certain respondents have submitted that the nature of a large cross may justify different treatment from that accorded to normal order flow. The Toronto Stock Exchange has a by-law change currently out for comment [20 OSCB 6217 (November 21, 1997)]. It suggests that for listed securities, agent-principal crosses ought not to be allowed on a quote matching basis if the bid-ask spread is more than one tick and the transaction is a principal trade for 5000 shares or less. The Vancouver Stock Exchange allows quote matching crosses only to the extent of 50% of the proposed cross irrespective of whether a dealer is counter party on one side or the trade is agency on both sides. A respondent has suggested that a cross should be submitted to full displacement by the existing bid/offer up to 10,000 shares.

Should the size of the cross and/or nature of the counter party be a consideration in determining the extent to which a secondary priority protocol be allowed to displace of all or part of a proposed cross?

D. OTHER ISSUES

1. Minimum Price Variation ("tick size")

The academic literature suggests that tick size must be sufficiently large to make raising or lowering a bid/offer price a significant decision. Otherwise bidders and offerors will find very little reward in entering orders and making the market.

First, if there is no standard tick size (or it is extremely small), any competing trader can better the existing best bid or offer by a tiny amount and, at very little cost, become the priority trader. For persons wishing to have priority an insignificant tick size necessitates continual monitoring and adjustment of their prices. It also means that secondary priority protocols providing for displacement on crosses becomes meaningless, as any price can simply be bettered by a fraction of a cent per share and the cross completed.

In order to encourage participants to enter bids and offers and to protect the notion of secondary priority, should the Commissions be willing to set standard tick sizes for a linked Canadian market?

2. Nature of Participants and Transactions in NETS

Should the Commissions have any concern about a NETS with a customer base that includes major Canadian and foreign investing institutions as subscribers having as additional customers:

a) foreign brokers representing foreign investors;
b) foreign dealers that make markets in Canadian securities; or,
c) Canadian dealers making markets:
i) to institutions only;
ii) to institutions and foreign dealers; or,
iii) to other Canadian dealers.

Would a NETS be a permissible market through which Canadian brokers and dealers could report crosses? Does it make a difference to your answer whether or not there is:

a) inter-market linking;
b) inter-market trade-through protection; or,
c) inter-market secondary priority?

Questions may be referred to:

Randee B. Pavalow
Policy Coordinator/Advisor
Ontario Securities Commission
(416) 593 - 8257

Hugh Cleland
Executive Director's Office
Ontario Securities Commission
(416) 593 - 8078

Joëlle Saint-Arnault
Chef du Bureau du President
Commission des Valeurs Mobilières
du Québec
514) 873 - 5009 Ext 237

Louyse Gauvin
Executive Assistant
British Columbia Securities Commission
(604) 899 - 6538

Eric Spink
Commissioner
Alberta Securities Commission
(403) 422- 1503

Marcel de la Gorgendière
Chairman
Saskatchewan Securities Commission
(306) 787 - 5645

Dated: February 27, 1998.

PUBLIC FORUM CONCERNING NETS AND MARKET FRAGMENTATION

PRESENTATION AND ATTENDANCE REQUEST FORM

Name(s):

Organization:

Business Address:

Business Telephone Number: ( )

Facsimile Number: ( )

Please Check One of the Following:

I/We Wish to Make a Presentation at the Public Forum

I/We Wish to Attend the Public Forum

Time Required for Presentation (maximum 60 minutes including questions):

Audio-Visual Requirements:

Please return completed form to:

The Commissions
c/o The Ontario Securities Commission
Suite 1800, Box 55
20 Queen Street West
Toronto, Ontario M5H 3S8
Telecopier: (416) 593-824
Attn: Randee Pavalow

Completed forms must be submitted by March 27, 1998.

SUMMARY OF COMMENTS RECEIVED
IN RESPONSE TO THE REQUEST
FOR COMMENTS CONCERNING
NON-SRO ELECTRONIC TRADING SYSTEMS
AND MARKET FRAGMENTATION 22-801
On May 16, 1997 the Ontario Securities Commission (the "OSC") published a request for comments and notice of forum concerning non-SRO electronic trading systems ("NETS") and market fragmentation (the "Request for Comments"). A notice requesting comments on issues raised in the Request for Comments was subsequently published by the Alberta Securities Commission ("ASC"), the British Columbia Securities Commission ("BCSC"), the Saskatchewan Securities Commission ("SSC") and the Commission des valeurs mobilières du Quebec ("CVMQ") after the ASE, BCSC, CVMQ and the SSC (together with the OSC, the "Commissions") notified the OSC that they were interested in participating in a joint public meeting on NETS.

The Commissions received a total of 12 submissions. Submissions were received from investment dealers, institutional investors, NETS owners/operators, stock exchanges and one law firm.

Commenters

Of the commenters only the Pension Investment Association of Canada expressly stated its interest in making a presentation at the forum concerning NETS regulation to be hosted by the Commissions in early 1998. However, each of McDermid St. Lawrence Securities Inc., the Toronto Stock Exchange , Versus Technologies Inc. and Instinet indicated that they were interested in participating in any further discussions concerning the issues surrounding NETS.

General Comments

The following submissions do not address any one of the specific topics outlined in the Request for Comments but are general comments relating to markets and market regulation.

For the protection of the retail investor, the Commissions should give serious consideration to maintaining the health of the continuous auction markets.

The Commissions should not address the issues of market fragmentation and NETS in isolation, but must first articulate a regulatory regime which addresses the primary issues as an integrated whole in a manner that will benefit investors and sustain healthy Canadian capital markets. In doing so the Commissions must keep in mind the guiding principles of regulation set out in the securities legislation to provide protection to investors from unfair, improper or fraudulent practices and to foster fair and efficient capital markets and confidence in the capital markets.

Any regulatory concerns regarding market fragmentation and transparency, should not focus on NETS alone. Absent material changes to the trading rules of the exchanges, irrespective of the introduction of rules regarding NETS, Canadian equity markets will remain fragmented and non-transparent.

Rules applicable to NETS should also apply to the dealers' upstairs trading desk, including the dealer's internal "off-exchange" order matching and management facilities or services. This is necessary to ensure that the system of regulation operates as a cohesive, rational, and consistent whole.

A. THE NATURE, CAUSES AND IMPLICATION OF MARKET CONSOLIDATION/FRAGMENTATION UPON MARKET QUALITY

1. The Causes of Fragmentation

Several commenters provided submissions on the types and causes of market fragmentation. The following types of fragmentation were identified by the commenters:

the dispersal of the buying and selling interest among competing exchanges resulting from interlisting of securities;

the "upstairs market" or the dispersal of buying and selling interest within a dealer's internal trading system; and,

competing liquidity pools in the form of proprietary electronic trading systems.

Foreign Markets

One commenter attributed the dispersal of the buying and selling interest among competing exchanges to Canada's history of being dependant upon foreign capital flows which leads naturally to the development of foreign secondary capital markets. This type of fragmentation, the commenter submitted, is probably the least troublesome because it arises out of natural market forces. A second commenter stated that anonymous electronic access systems will attract capital to those countries and exchanges which allow access directly or through broker guaranteed electronic networks because money managers find that transaction costs are reduced.

One commenter noted a market should only be considered fragmented when real or artificial barriers prevent it from maximizing its performance in terms of liquidity and price discovery and, absent artificial barriers, a market is not necessarily fragmented merely because it is not centralized at a single location. The existence of more than one market access point is not synonymous with fragmentation nor is competition amongst market service providers so long as there is unrestricted access to all market access points and consolidated market information.

Upstairs Market

A commenter submitted that the development of the "upstairs market" arose primarily out of two concurrent developments, the liberalization of the agency/principal rule and the sweeping concentration of the brokerage industry as firms merged and/or were swept into the orbit of other financial institutions. Another commenter noted that the exchange rules have accommodated the "upstairs market" but also attributed the evolution of that market to several other factors including; the development of order management systems that facilitate the crossing of dealer orders, the development of internal order management systems which facilitate internal crosses, the institutionalization of the marketplace, and the fee structure of the exchanges which makes upstairs trading more economical than transacting through the central order book of an exchange.

2. The Impact of Fragmentation

Retail Market

One commenter noted that market fragmentation potentially impacts retail investors in a number of ways, some of which may be considered to be beneficial to the retail investor. These include providing a choice of markets and currency in which to trade any particular security and potentially increasing the liquidity of any particular stock. The commenter noted that while multiple markets may result in greater liquidity for any particular security, non-integration of price discovery mechanisms may prohibit an investor from determining the best market for a particular security at any particular time and may derogate from the goal of best execution. The commenter also submitted that the internalization of retail order flow denies the retail investor the greatest opportunity for price and time priority protection without the offsetting benefit of confidentiality and anonymity. Finally, the commenter noted that it would be beneficial for retail investors if all retail orders under a certain size received by a dealer were required to be automatically routed to the best market and not accumulated for internal execution.

Price Discovery and Viability of Order Book

One commenter noted that the internalization of orders has had a significant effect in reducing the visible liquidity of the central market place thereby compromising short-run price discovery.

It was noted by one commenter that market fragmentation has many implications including the potential for inconsistent regulation among the growing number of separate liquidity pools.

One commenter submitted that exchange rules regarding non-displacement of crosses and pro rata priority act as a disincentive for limit traders to place their orders on the central book of the exchange. The commenter made two suggestions to increase the incentive for a trader to place limit orders in the book. The first is to change the cross- interference rules to provide that crosses must improve on the best price to avoid interference. The second is to operate the book on a strict price and time priority basis and to do away with the pro rata rule.

Innovation and Competition

Several commenters provided general responses to this topic. One stated that competition between exchanges would ensure ongoing innovation, enhanced service levels, and improve cost efficiencies of markets in Canada. It would also allow for the ongoing development of different types of markets including dealer/ market-maker markets, continuous agency auction markets and call markets and even though each of these types of markets has its disadvantages their development is valuable as they offer the investor different types of services.

A second commenter submitted that absent a shift in regulatory focus towards encouraging competition and innovation, further fragmentation and a diminished role for Canadian stock exchanges is inevitable. Fragmented markets tend to benefit intermediaries, while centralized markets tend to favour investors and issuers. Regulators should concern themselves with the latters' interests; market forces should determine the formers'.

A third commenter noted that alternative trading systems are an opportunity to add new capabilities to a Canadian market system, provided that all of the components of that system function within a coherent regulatory framework with a level playing field, with free access to the market and market information, and with the innovation and price reduction benefits of true competition.

B. NETS, THEIR EFFECT ON FRAGMENTATION, RECONSOLIDATION OF MARKETS, AND OTHER ISSUES RELATED TO NETS

1. NETS and Currency

More than one Currency

One commenter stated that a significant priority of the Commissions should be to maximize the liquidity provided by exchanges in Canada regardless of currency and that Canadian securities quoted in US dollars by a NETS or traditional exchanges in Canada could attract, by virtue of denomination, order flow from the United States to Canada. While the commenter noted that the quoting of Canadian securities in both Canadian and US dollars could detrimentally affect visible liquidity in those stocks on Canadian exchanges, it concluded that the benefits of quoting in both denominations outweigh the costs where fair foreign exchange facilities are available.

One Currency

At the other end of the spectrum, one commenter stated that all prices must be expressed in a common form in all trading systems. Another commenter took a similar view indicating that the same security in the same country should be quoted in a single currency to avoid the net effect of excessive fragmentation and loss of liquidity. The customer should not have to deal with currency conversions, or different dealer rates or spreads in order to have true price discovery. The comments also stated that Canadian listed securities should be quoted on a NETS in the same currency as that of the exchange where the security is listed.

Uniform Approach

One commenter did not provide an explicit view on the currency questions posed but made the general comment that the currency display requirement regarding bids and offers and transaction reports should be uniform for all dealers and others, including exchanges, that offer "off-exchange" matching services in Canada.

2. NETS and Price Discovery

Integration with Exchanges

One commenter submitted that NETS should be conduits to the exchange on which the security is listed to ensure price discovery and order priority.

Treat the Same as Upstairs Markets - Require Disclosure

One commenter stated that intermediaries should be obliged to disclose fully and accurately all orders unless in receipt of contrary client instructions. Another commenter submitted that the price matching parameters of off-exchange systems should be regulated to respect cross interference rules to ensure all market participants of price priority which would require disclosure of the best order price within any particular NETS.

It was noted that unless the traditional upstairs market is subject to the same rules, a regulatory approach which requires full disclosure of order flow on NETS would defeat the purpose of NETS from the perspective of the institutional investor. If order confidentiality and anonymity are not maintained, the purpose of both the NETS and the "upstairs market" would be defeated.

Anonymity and Non-disclosure on Exchanges

Two commenters took the view that trades through NETS should be regulated in the same manner as the "upstairs market" which permits dealers to post crossed block trades while maintaining the confidentiality and anonymity of the client orders.

One commenter expressed the view that the upstairs market may be appropriate for the negotiation stage of large orders. However, the commenter went on to state that the upstairs market should not be used to avoid displacement of orders in the central market and client orders should not be accumulated and crossed in the upstairs market in order to avoid exchange trading costs as the price could move away from the client in the interim.

One commenter submitted that inferior bids and offers on NETS should not be required to be displayed to non-NETS participants as long as NETS participants are not permitted to trade through superior bids and offers existing on the consolidated market. A similar view was taken by another commenter who submitted that if the "upstairs market" is to be preserved, it should be the client who decides whether a block quote should be published.

One commenter expressed the view that exchange systems can fairly and readily be adapted to meet investors' needs for anonymity and non-disclosure of broker identification and size of order however, it questioned the need for such adaptation in light of its opinion that from a public interest perspective, there are very few circumstances which warrant non-disclosure.

One commenter stated that market quality in respect of venture companies would be particularly adversely affected if the true market and its depth are not consolidated and immediately disclosed. In its view, the public interest would not be served if the "inside market" for an actively traded security could not be ascertained by investors.

The same view was taken by another commenter who submitted that there should be real time reporting of all pre-trade and post-trade information by all competing trading systems. Another commenter stated that NETS should be required to post all trade information in a timely manner to ensure the information is available to all market participants. It is unclear whether the commenter was referring to both pre-trade and post-trade information.

3. NETS and Reconsolidation of Fragmented Markets

Integration of Trading Activity with Exchanges

Three commenters took the view that NETS should be permitted to operate in Canada provided they become a member firm of a recognized Canadian exchange and their trading activity is integrated with and subject to the rules of that exchange. One commenter noted that this would result in minimum fragmentation and ensure optimization of the essential attributes of fair and efficient markets such as price priority, price discovery, transparency and liquidity while providing the potential of attracting increased order flow.

One of the three commenters were of the view that integration with an exchange should be an interim measure and that NETS should eventually be entitled to operate as entities separate and apart from an exchange subject to appropriate regulatory responses to certain issues including order visibility, order aggregation, and market surveillance. A second of the commenters stated that it was not in a position to determine whether NETS should be permitted to operate apart from exchanges until such time as a regulatory regime is determined.

One of the three commenters submitted that if NETS are allowed to operate in parallel to a traditional exchange for trading purposes, this will create further market fragmentation and dilute the market.

A fourth commenter submitted that the public interest role of a SRO makes it incumbent upon them to accommodate alternative technology initiatives which offer additional benefits to the investor. SROs should be prepared to welcome alliances with NETS and such alliances should be encouraged by the establishment of a regulatory framework which puts both the SRO and NETS on a level playing field. The commenter stated further that there is no reason why an SRO cannot integrate alternative trading facilities via the membership connection.

Independent Operation

One commenter submitted that NETS should be permitted to operate in parallel with exchanges and have the option of being regulated directly by the Commission as an exchange or by an SRO as a dealer.

4. NETS and Nature of Integration with Traditional Exchanges

Consolidated Tape

Several commenters expressed the view that a consolidated tape should be instituted in Canada and that reporting trade information on such tape should be mandatory. One of these commenters stated that all post-trade reports should be required to be reported on the consolidated tape.

It was noted that market transparency and market price discovery will be inhibited if trade reporting does not occur. However, the commenter stressed that if Canadian transactions are permitted to be reported on foreign exchanges, the upstairs trading of all dealers might be reported in such a manner that those dealers would be able to avoid Canadian exchange rules with respect to displacement of crossing transactions, trade reporting requirements and exchange trading costs which would lead to diminished transparency and regulatory arbitrage.

Displacement

One commenter submitted that the retail investor would benefit if retail orders are immediately routed to the "best market" for any particular security thereby preventing the internalization of order flow and ensuring the investor of the greatest opportunity for price and time priority protection. The commenter proposed that orders above a particular size could be crossed in a NETS or in the "upstairs market".

A second commenter proposed linking the different markets to permit a "seamless" automatic routing of orders to the most competitive trading system (e.g. lowest transaction cost) while respecting price priority among the competing trading systems. This commenter did not suggest restricting the requirement to orders under a particular size.

It was also submitted that all trading systems (exchanges and NETS) that are regulated as exchanges should not be allowed to refuse the electronic routing of orders to their respective marketplaces for immediate execution.

One commenter stated that any details of orders available to NETS participants should be available to all investors to enhance price discovery. In addition, all investors, whether NETS participants or not, should be able to access the NETS liquidity pools to prevent trade throughs.

5. NETS and Functional Regulation

Participation by Registrants

The comments ranged from the suggestion that registrants be prohibited from trading on NETS and should be prohibited from establishing or maintaining a NETS to the view that exchange members could be allowed to participate in NETS as long as they continue to be subject to the rules and regulation of their particular SRO. The former submission suggested that such a prohibition would confine the trading activities of registrants to existing monitored trading facilities. The latter commenter submitted that imposing restrictions on exchange members' participation in NETS would only encourage further fragmentation of, and disruption to, the marketplace.

Another commenter took the view that NETS could be of two kinds: ones that are members of traditional exchanges and ones that become regulated as exchanges. All investors (both institutional and retail) who wish to access exchanges (traditional exchanges, or NETS which become regulated as exchanges) should be required to do so by transacting through registered investment dealers. Transacting through registered investment dealers puts responsibility on these dealers to ensure that exchange regulations are followed with respect to all exchange trading, and that the interests of institutional and retail investors are protected which goes to maintaining the integrity of the regulatory system.

Market Surveillance

Two commenters submitted that the current regulatory structure and the roles of the exchanges and commissions could be expanded to cover NETS and that surveillance of NETS should be integrated with that of other systems to provide an overall picture of market activity. The exchanges have the infrastructure to undertake, and should undertake, the market surveillance of all NETS. Surveillance by NETS of their own activity would not present a fair view of the market and may create the opportunity for manipulative practices on any particular NETS. One of the commenters also stated that NETS should be required to assist the exchange in exchange trading investigations. A third commenter diverged on the role of exchanges and submitted that supervision and surveillance of NETS should be undertaken directly by the securities commissions to prevent the possibility of competitive misuse of regulatory authority.

Capacity and Integrity of System

One commenter submitted that as competition becomes the norm, it is reasonable to assume that customers will take the responsibility of ensuring the capacity and integrity of the systems upon themselves, rather than relying upon regulators to determine and provide the requisite level of assurance. If regulators limited their role to setting clear minimum standards for transaction processes, it is reasonable to anticipate the development of third-party surveillance firms, analogous to credit rating agencies, to oversee and report on the integrity of trading systems.

6. NETS and Cross Border Securities Regulation

Home \Host Model

One comment addressing this issue provided that a SRO-sponsored ETS should be able to operate in a Canadian jurisdiction under a "home/host" regulatory regime provided the commission in the Canadian jurisdiction is satisfied that home jurisdiction regulation meets certain standards for investor protection and market integrity, that reciprocal information and enforcement agreements are in place, and that exchanges here have reciprocal access to the home foreign jurisdiction.

A second commenter stated that provided the foreign institution or market intermediary is simply a client of a Canadian broker-sponsor of a NETS, there is no registration issue arising in Canada. The Canadian broker-sponsor may face a registration requirement itself in the foreign jurisdiction. The situation is different however for a foreign market intermediary wishing to utilize a NETS in Canada to act in the capacity of broker for a Canadian client as current restrictions designed to preserve certain Canadian equity business to the Canadian broker would apply and therefore there is no need to revisit the registration regime applicable to foreign market intermediaries.

The commenter submitted further that in respect of securities, while the means for qualifying securities for trading in the Canadian marketplace may always be subject to change, they see no reason for introducing change to the existing regime for qualifying securities because of the present initiative. Under the existing regime, assuming the adoption of an integrated approach to regulation, since NETS operators are brokers, and not markets per se, the securities qualification requirement would have to be met in each jurisdiction in which trade activity is engaged in by the NETS operator.

Reciprocity

A commenter stated that a great deal of weight should be put on matters of reciprocity between jurisdictions and that concessions should not be granted to foreign competitors unless Canadian regulators are aware of the positions of the reciprocal jurisdictions.

C. ROLE OF THE COMMISSIONS

Active Role for Commissions

One commenter submitted that the provincial securities commissions should assume the role of primary regulator in respect of "off-exchange" trading systems offered to market participants to ensure that regulation is impartial and is not motivated by self interest or anti-competitive intent.

Industry Approach

One commenter suggested that while the integration of NETS could be achieved by commission rule-making, allowing the industry to devise appropriate structures to achieve the objective would be preferable if the industry can comply within a reasonably short time frame. The commenter also added that the Commissions should set objective operational standards for market centre operators, including a requirement for all bid/offers to meet in a price/time environment, and then let them operate as they wish without extensive ex ante regulatory approvals. Regulatory oversight should be consolidated in a national agency to minimize the harmful effects of duplication, regional competition and regulatory arbitrage.

The commenter stated further that technology and market forces, if allowed to evolve freely, will quickly create a range of different trading systems than those offered by "traditional" markets and suggested that flexible "fair trading" rules that are strictly enforced are a more appropriate and achievable regulatory focus than "uniform" regulation of market structures. The commenter stated that it wasn't apparent how a securities regulator's mandate is advanced by imposing SRO requirements on alternative trading systems.

Public Goods

One commenter submitted that the presence of non-integrated NETS should not derogate from the "public goods" types of services provided by an exchange and an acceptable cost sharing arrangement should be in place to prevent free- riding by NETS.

A second commenter submitted that in a non-integrated scenario it would not be appropriate for private NETS to compensate exchanges for their "public good" type services. In their view, NETS will also be providing "pubic good" types of services for which they will not be compensated.