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

REQUEST FOR COMMENTS AND NOTICE OF FORUM TO
DISCUSS "NETS" AND MARKET FRAGMENTATION

Electronic trading systems ("ETSs") are screen-based computer systems that automate all or part of the traditional trading process. For example, they canautomate order handling within a brokerage firm, facilitate order routing from a brokerage firm to a stock exchange, or take the place of a stock exchangetrading floor. ETSs may be sponsored by a recognized self-regulatory organization ("SRO") or by an entity that is not a SRO.

Over the past decade, the use of ETSs not sponsored by SROs ("NETS"--non-SRO sponsored ETSs) has grown significantly in many jurisdictions, particularlyin the United States ("US"). Securities regulators in Canada have been engaged since 1988 in discussions of the appropriate role of NETS. See Appendix "A"for historical background. In September 1995, the Instinet Corporation was granted registration as an international dealer which permitted it to provideterminals to Ontario Designated Institutions (as defined in s. 204 of the Regulation to the Act). A request for a hearing and review of the decision was made bythe Toronto Stock Exchange, Vancouver Stock Exchange, Montreal Stock Exchange and Alberta Stock Exchange. Although the requests for the hearing weredenied the decision of the Commission stated:

"We are of the view that a process should be put in place through which the Commission can obtain meaningful data and input concerning the issue offragmentation of the markets in Canada, from those with knowledge and an interest in the issue. Those could include the SROs and representatives of investors,issuers, advisers and dealers, including dealers who carry on business by way of electronic trading systems. We are interested in hearing about the nature, causeand extent of all fragmentation (and lack of transparency) which may be related to the number of exchanges in Canada, the trading rules of the Canadianexchanges, the "upstairs" market and electronic trading and information systems operating in Canada. We are particularly interested in data as to actualfragmentation and its effects, rather than prospective speculation. We are also interested in hearing the views on what negative effects fragmentation has onvarious market participants and on the Canadian markets generally, and how those negative effects balance out against developments that may be leading to thefragmentation." ((1995)18 OSCB 5439 at 5453).

At this time, the Commission is seeking information from interested parties (including stock exchanges, NETS, brokers, dealers and investors) with a view todeveloping an appropriate regulatory framework for the operation of NETS. The Commission intends to convene a public meeting in September 1997 (the exactdate to be announced) to discuss and consider submissions regarding NETS.

The purpose of the public meeting in September 1997 is to permit all interested parties to participate in the discussions relating to the implications of marketfragmentation and the development of the regulatory model which will govern NETS, including consideration of the following matters:

1. the causes and implications of market fragmentation;

2. the basis on which NETS should be permitted to operate in Canadian securities markets;

3. proposals for new regulations and the role of the Commission in connection therewith.

Interested parties who wish to participate at the open meeting are invited to file written submissions and requests for appearances by July 15, 1997.

It is anticipated that Commissioners will preside over the meeting. Other CSA jurisdictions have been invited to participate. Staff will not make submissions butwill participate as observers.

The open meeting will be informal. Presentations may be made by counsel, experts, and employees of market participants. Only Commissioners will be allowedto question those who give oral presentations. However, others may provide contrary evidence as rebuttal. Presentations will be limited to one-half hour unlessotherwise justified. A transcript of the proceedings will be made. The final decision regarding the details of the process will be announced after CommissionStaff have reviewed the submissions and discussed the process with the interested parties.

Appendix "A" sets out a brief historical background to the operation and regulation of NETs, which supplements the staff paper entitled "Electronic TradingSystems in Ontario" prepared in 1994 (cited and discussed in Part B of Appendix "A").

In order to focus discussion, Staff have identified the following issues and questions which they believe will assist the Commission. The questions are organizedunder three headings: (A) Market Fragmentation/Consolidation, (B) NETS, their effect on fragmentation, reconsolidation, and other issues related to NETS (C)The Role of the Commission. In addition to the questions set forth below, Staff have provided in Appendix "B" background information and have identifiedcertain specific operational questions in order to obtain detailed facts and comments on operational issues that, in staff's view, would assist the Commission in itsdetermination with respect to an appropriate regulatory framework for NETS. However, interested parties need not respond to all of the questions set outbelow or in Appendix "B". All information and comments relating to the issues are welcome.

A. The nature, causes and implication of market consolidation/fragmentation upon market quality.

1. Identify the causes of fragmentation in the Canadian Markets?

2. How important is this kind of fragmentation to overall market quality?

B. NETS, their effect on fragmentation, reconsolidation of markets, and other issues related to NETS.

1. NETS and Currency;

With respect to a NETS operating in Canada in Canadian listed securities, should negotiations between the customers of the NETS, i.e. the system's bids andoffers, be displayed in Canadian dollars or is it acceptable for the system to operate in a foreign currency (US dollars)?

2. NETS and Price Discovery;

Is it appropriate for institutions and dealers to avoid the present disclosure/transparency systems of the exchanges by using NETS?

If so, what are the implications of the exchanges providing a similar facility to meet an investor's desire for anonymity and non-disclosure ?

Does it matter to market quality whether the bids and offers entered on NETS or transactions negotiated on the NETS are made public on a timely basis? Towhom and when?

In balancing the interests of an efficient capital market which includes transparency, when, if at all, is the current operation of an "upstairs" market appropriate?

3. NETS and Reconsolidation of Fragmented Markets;

Should NETS be allowed to operate in parallel with traditional stock exchanges or should they be integrated with them? If integration is appropriate, howshould they be integrated?

Are there circumstances when bids and offers in NETS should be made available to parties outside of the NETS? For example, when the bids and offers are at abetter price on the NETS than is available on other markets? Or, alternatively, when a bid or offer has been accepted on a NETS at a price that is inferior tobid/offer prices that are available in other markets that make their information available to the public ("public markets").

4. NETS and Integration with Traditional Exchanges;

What is the appropriate degree of integration of NETS with exchanges with respect to: transaction reports, displacement rules, display of bids and offers,tradeability of bids and offers between systems?

If matters such as centralized reporting (to avoid fragmentation of information) and price and time precedence for orders are important, how should such goalsbe achieved in a fragmented market?

5. NETS and Functional Regulation; and

Should a NETS operating in Canada in Canadian securities be restricted from accepting traditional exchange members and other market intermediaries as users?

Would functional regulation of NETS require that the Commission supervise all NETS directly with respect to prevention and detection of manipulative ordeceptive activity by its users?

6. NETS and Cross Border Securities Regulation.

How much weight should be put on matters of reciprocity between jurisdictions? Please explain.

C. The role of the Commission.

To what extent is present internal and external fragmentation of markets for Canadian stocks a problem that should be addressed by the Canadian exchangesand/or securities commissions? What, if anything, should be done?

The material in Appendices "A" and "B" set forth important background discussion and additional detailed questions to the ones set forth above. Interestedparties should feel free to raise and discuss other issues which they feel will be useful to the Commission's deliberations.

All interested parties are invited to provide written submissions and requests for appearances by July 15, 1997, which may be sent to:

Mr. Dan Iggers
Secretary
Ontario Securities Commission
20 Queen Street West, Suite 1800
Toronto, Ontario
Canada M5H 3S8

Written submissions will be publicly available unless confidentiality is requested. However, we note that the Commission's ability to maintain confidentiality issubject to the Freedom of Information and Protection of Privacy Act (Ontario).

Questions may be referred to:

Randee B. Pavalow
Policy Coordinator
Ontario Securities Commission
(416) 593-8257
Hugh Clelland
Executive Director's Office
Ontario Securities Commission
(416) 593 - 8241

Dated: May 16, 1997.

Appendix "A" - Historical Background Relating to the Operation and Regulation of NETS in Ontario

A. Application of Instinet Canada Limited for membership in the TSE - the 1990 Hearing

In the late eighties, Instinet Canada Limited ("ICL"), an affiliate of Instinet Corporation ("Instinet US"--which is the sponsor of the Instinet Systems), purchaseda seat on the Toronto Stock Exchange ("TSE") preparatory to commencing business in Ontario. ICL applied for TSE membership in early 1988.

ICL's membership application led to detailed discussions in 1988 and 1989 between representatives of ICL and the TSE about the manner in which various TSErules operated and what services Instinet could offer in Canada as a member. Certain members of the TSE ("the Dealer Group") strongly opposed ICL'sadmission to membership, in part, on the grounds that the operation of the system would fragment order flow and significantly detract from liquidity on the TSE.ICL maintained that the Canadian market was already fragmented and that, in any case, it did not propose to do anything that present members of the TSE werenot permitted to do. The Commission was asked to intervene .

In accordance with the Commission ruling in 1989, ICL was admitted to TSE membership and the TSE appointed a Rule Review Committee. The Committeewas directed to examine whether changes to the Exchange's trading rules were necessary to improve market quality and reduce fragmentation in anticipation ofthe imminent admission to TSE membership of Instinet and other such systems. Under an agreement with the TSE and the Dealer Group (the "InterimArrangement"), Instinet agreed not to install any terminals in Canada while this study was being conducted.

The Rule Review Committee reported in December, 1989. It recommended some changes to then existing trading rules of the TSE and also proposed a new setof rules (labelled "COMAC Rules" for Computer-based Market Access) to govern the operations of a TSE member like ICL that relied on a computercommunications network to carry on its brokerage business.

A hearing (the "1990 Hearing") was held by the Commission to consider both the recommendations of the TSE Rule Review Committee and also ICL'sproposals for participation in the Canadian market, assuming the promulgation of the proposed TSE trading rule changes. At the 1990 Hearing, the functions ofthe Instinet system were considered in detail.

The international scope of the Instinet system's negotiating/order matching capability and its intention to report matched orders to foreign stock exchanges,rather than on the TSE, were primary issues. Other issues regarding ICL's proposed entry into Ontario included:

1. whether ICL should be regulated as a stock exchange or dealer;

2. the potential for market fragmentation in TSE-listed stocks as a result of ICL's activities and;

3. whether ICL's proposed method of operation would provide unfair competition to the local dealer community.

Ultimately, the Commission found most of the trading rule changes proposed by the TSE to be desirable, and most of them were implemented, but theCommission did not deal with the COMAC Rules. In addition, the Commission expressed concern about the implications of potential increased fragmentation ofthe market for Canadian-listed stocks that would be caused by the participation of NETS. In the absence of agreed rules governing electronic trading systems,the Commission did not have to make a determination on the other issues. Pending implementation of the TSE's rules changes and more study of thefragmentation issue, the Commission confirmed ICL's TSE membership and registration of ICL as a broker with the OSC and continued the InterimArrangement.

ICL commenced operations in Canada in 1993 as a TSE member. The Interim Arrangement allows ICL to serve Canadian accounts in Canadian and foreignsecurities but only on the basis that its customers would use a telephone to give orders to ICL trading employees, who would then key the orders into theInstinet System.

B. Electronic Trading Forum Sponsored by the OSC - June 1994

With a view to ensuring that its policy efforts remained responsive and relevant to market participants and to further facilitate the interchange of information,opinions and ideas regarding NETS, the Commission published a paper entitled "Electronic Trading Systems in Ontario" (the "1994 Paper") in May 1994 (17OSCB 2512) and hosted a forum to discuss the issues in June 1994. Participants in the forum included academic and regulatory experts from the US, the UnitedKingdom and Australia, as well as interested Canadian parties. Speakers represented a broad spectrum of views and included representatives of NETS sponsors,institutional investors who use NETS, stock exchanges and regulators from Canada, the US and Australia. There were over 300 attendees including members ofIOSCO's Working Party No. 2.

Due to the quality of the presentations at the forum and their valuable contribution to the discussion regarding NETS, Ontario Securities Commission staff("Staff") assembled and edited the presentations, publishing them in a monograph entitled Electronic Trading Systems: OSC Forum Proceedings (1995: Queen'sPrinter for Ontario). The Commission has decided that the 1994 Paper along with the additional information contained in this notice be used again asbackground material for the proposed Public Meeting (as discussed in Part IV, below).

C. Versus Brokerage

In early 1995, Versus Brokerage Services Inc. ("Versus Brokerage") was registered as a broker. Versus Brokerage is a subsidiary of Versus TechnologyIncorporated ("VTI") -a technology provider to the Canadian securities industry. The principal offering of VTI is a terminal network that permits member firms,as well as investing institutions and foreign dealers operating under TSE Policy XXX1, to route orders to the TSE. Versus Brokerage participates in the VTInetwork and seeks to offer value-added services to institutional clients. The initial service offering of Versus Brokerage provided for anonymous posting ofindications of institutional buying and selling interests on an electronic bulletin board. A second product was provision of an intra-day call market forinstitutional clients.

D. Registration of Instinet US as an International Dealer

In September, 1995 Instinet US was granted registration as an international dealer, which permitted it to provide terminals to Ontario Designated Institutions2to trade foreign securities which are not listed on a Canadian stock exchange directly on the Instinet network. The approval provided by the Commission'sdecision (the "Decision") was subject to certain terms and conditions ((1995)18 OSCB 5439).

The terms and conditions of the Decision enables Commission staff to monitor the impact of the Instinet system on the market and to evaluate how it performsits market functions. To a large extent, staff relied on the reporting system that had been recently adopted in the US under SEC Rule 17a - 233.

E. Request for Review of Staff's Decision to Register Instinet Corporation

The TSE made a request to the Commission under subsection 8(2) of the Act for a hearing and review of the decision to register Instinet US as an InternationalDealer. The Montreal Exchange, the Vancouver Stock Exchange (Alberta) and the Investment Dealers Association of Canada made similar requests and, in thealternative, requested intervenor status. The requests for a hearing were denied and Instinet's registration was confirmed.

F. Commission Request for Resolution of Fragmentation Issue and Role of NETS

As part of the Instinet Decision resulting from the 1995 hearing, Commissioners Waitzer, Smart, Geller, Moore, and Carscallen concluded that a process shouldbe put in place through which the Commission could obtain meaningful input on the issue of fragmentation.

G. Report of the TSE's Special Committee on Market Fragmentation

The TSE released the report (the "TSE Report") of its Special Committee (the "SC") on Market Fragmentation in January, 1997. The TSE Report provides theSC's analysis of the current extent of, and future trends in, the fragmentation of equity markets in Canada. It makes recommendations for specific trading rulechanges aimed at reducing internal fragmentation. It also suggests some possible frameworks for permitting Proprietory Electronic Trading Systems ("PETS")4in the Canadian securities market. The following sets out the SC's major conclusions and recommendations

1. Market Structure

An order-driven auction market should continue to form the foundation of the TSE's market structure with the flexibility to allow dealers to provide liquiditywhere necessary. This was a fundamental premise of the SC's analysis of the TSE's role and the market fragmentation issues it addressed.

2. The Attributes of an Ideal Market

The SC adopted the following attributes as a framework of analysis for addressing the impact of market fragmentation:

a) market liquidity;

b) immediacy;

c) visibility (or "transparency");

d) price discovery;

e) transaction costs;

f) fairness;

g) integrity of the credit ring;

h) integrity of the market.

3. Proprietary Electronic Trading Systems

The SC concluded that an appropriate regulatory framework for PETS should ensure that the off-exchange trading is integrated sufficiently into the marketsystem to achieve the following: prevent excessive loss of liquidity on the TSE; ensure visibility and the effectiveness of the price discovery process; ensurefairness; and enable effective surveillance of trading and the enforcement of a common set of rules of conduct for participants.

The SC recommends PETS be permitted to provide trading services in listed securities immediately, provided that the PETS is subject to the oversight of anappropriate self regulatory organization, and, operating as a member firm, integrates its trades with the TSE's or another recognized Canadian exchange's market(TSE Report, p. 52).

4. Internal Fragmentation

With respect to internal fragmentation, the SC concluded that the attributes they had identified would be enhanced by requiring members to send immediately tothe Exchange any orders of less than 1200 shares and by barring members from dealing from inventory with their own customers' orders for less than 5000shares unless they provided a better price than the Book.

The TSE has requested comments on the TSE Report and will be holding a forum on the issues in June, 1997.

H. Review of US Regulatory Approach

SEC Rule 17a-23 became final in December, 1994 with an effective date of June, 1995. It applies to "broker- dealer trading systems" (BDTS) that meet thefollowing criteria: the system must provide a mechanism, automated in full or in part, for (1) collecting or disseminating system orders and (2) matching,crossing, or executing system orders, or otherwise facilitating agreement to the basic terms of a purchase or sale of a security between system participants, orbetween a system participant and system sponsor, through use of the system. The SEC concluded that Rule 17a-23 should apply to automated dealer systems, aswell as other BDTSs, on the basis that systems that automated execution functions make it possible for a broker-dealer to concentrate a significant volume ofsecurities transactions. Rule 17a-23 applies to systems trading equity as well as non-equity securities. Rule 17a-23 focuses on enhanced record keeping andreporting.

Under Rule 17a-23, Sponsors are required to keep and make available to the SEC upon request, records of (1) daily summaries of trading in the system; (2) theidentities of system participants; and (3) time-sequenced records of each transaction effected through the system. The sponsor is also required to file reports inaccordance with Form 17a-23 which contains three parts: (1) operation reports including initial operation reports and subsequent reports prior to implementingmaterial system changes; (2) quarterly reports; and (3) a final report within 10 days after it ceases to operate its trading system.

Appendix "B" - Additional Background Information and Specific Questions

A. Market Fragmentation/Consolidation

Background

The 1994 Paper (page 92-101) and the SC Report provide extensive discussions of the theory and also of the existing circumstances related to fragmentation.According to the SC Report, market fragmentation is:

"The dispersal of orders among different exchanges or liquidity pools.

External fragmentation is the dispersal of buy and sell orders for the same security over different liquidity pools--i.e. among different trading systems or amongdifferent markets.

Internal fragmentation is the dispersal of buy and sell orders for the same security by brokerage firms or investment dealers that retain and match their own clientorders within their own organizations.

Temporal fragmentation is the dispersal of buy and sell orders for the same security over time. This type of market fragmentation results from timing differencesamong investors regarding when to buy and sell the same security."5

Issues

1. It is apparent that Canadian markets are currently somewhat fragmented. This is a consequence both of factors internal to the exchanges in Canada (i.e.member practices that are permitted by exchange rules) and also of external factors (i.e. many listed securities are traded on other Canadian and/or foreign stockexchanges).

a. Identify the causes of fragmentation in the Canadian markets.

b. How does the current level of fragmentation impact retail investors and what kinds of changes to the current market structure relating to fragmentation woulda) favourably and b) unfavourably impact on retail investors?

c. Does fragmentation have an impact on limit order traders? If yes, describe the kind of impact and indicate whether the effects on market quality aresignificant.

d. To what extent can the stock exchanges and their members address "external fragmentation"? How important is this kind of fragmentation to overall marketquality?

e. How should the SC's proposals on internalization and order disclosure be integrated with how the Commission should deal with NETS?

Background

2. The 1994 Paper describes the "upstairs market" (pages 99-101). That market is, by nature, fragmented as all orders in it are bi-laterally negotiated eitherbetween a potential contra party and a broker who is acting for a client, or between an institution and a dealer who is offering to be contra party in a principaltrade. The connection between the upstairs market and an exchange Order Book is that a transaction agreed to in the upstairs market (whether as agent orprincipal) only becomes formalized as a trade when it is reported on a stock exchange and subjected to the applicable rules concerning displacement.

Issues

a. What constraints, if any, should be put on exchange members in respect of how they deal with institutional (large block) orders?

b. Should any constraints be placed on the freedom of institutions to handle their orders in the manner they feel will provide most favourable executions?

B. Non-SRO Electronic Trading Systems (NETS), their effect on fragmentation, reconsolidation of markets, and other issues related to NETS.

Background

The 1994 Paper (pp. 102-121) describes the types of NETS that are available and the services that they offer. Instinet and POSIT have had commercial successin the US.

POSIT offers US institutions and broker dealers facilities for periodic order matching. Periodic matching services are of particular interest to index funds whereminimizing execution costs and duplicating the performance of an index are paramount goals.

Instinet is active in Canada and offers two levels of service. Under its registration as an International Dealer granted in September 1995, Instinet Corporation("Instinet US") has installed trading terminals on the trading desks of a significant number of institutions in Canada. Those terminals provide full service inforeign (non-Canadian) securities (i.e. specific negotiation, order book "hit and take", Crossing Network, and Market Match). The terminals have beenrestricted from accepting orders in any security listed on an exchange in Canada. However, Instinet terminals on the same system but located in the US acceptorders on approximately 200 Canadian-listed securities that are also listed on a US exchange or Nasdaq. In addition, the institutional terminals installed inCanada carry information concerning the markets for, and trading of, those Canadian securities in the system.

Instinet Canada Ltd., an affiliate of Instinet US, registered in Canada as a dealer and a full member of the TSE, has terminals on its own trading desk which arenot prohibited from trading Canadian listed securities in the US Instinet system for its Canadian clients. Traders for Instinet Canada take orders by telephonefrom Canadian customers and execute them through the system.

1. NETS and Currency

Background

Bids and sell orders, offers and buy orders can only meet directly when they are denominated in the same currency. Matching buying and selling interests whichare stated in different currencies requires the interpositioning of an arbitrageur who will buy in one currency and sell in the other when a profit appears to berealizable.

Issues

a. With respect to a NETS operating in Canada in Canadian listed securities, should negotiations between the customers of the NETS, i.e. the system's bids andoffers, be displayed in Canadian dollars or is it acceptable for the system to operate in a foreign currency (US dollars)?

b. For purposes of market information disclosure, should transaction reports and any information concerning bids and offers, originated by Canadian customersof the NETS, be disclosed/reported in Canada or is it acceptable for such information to be made public through the reporting system operating in the US?

c. To what extent would fragmentation concerns be answered by requiring electronic trading systems that operate in Canada to 1) denominate bids, offers andtrades in Canadian securities in Canadian dollars, and 2) report transactions to the market information vendors in Canada and to the Canadian ConsolidatedVendor Feed ("CCVF") for dissemination outside of Canada?

2. NETS, Market Transparency and Price Discovery

Background

The TSE Report states that institutions wish to be able to utilize NETS (in part) in order to reduce the "market impact" of their orders and transactions in themarket. NETS help institutions avoid market impact by permitting orders to be entered to the Order Book directly or to be shown to other institutions withoutdisclosing to an intermediary about the buying or selling interest. An institution may also use the selective disclosure protocol of a NETS, rather than have itsorders in a stock exchanges order Book. In this way the institution can avoid the exchange's disclosure regime with respect to booked orders exposed.

Issues

In this context, and given facilitating regulations, NETS could provide institutions the possibility of using an exchange when it suits them, and using a NETSwhen either they wish to avoid the market information disclosure regime of the exchanges or when they want to avoid disclosing their interest to a dealer (i.e.they believe the involvement of a dealer will be counter-productive to obtaining favourable execution).

a. Is it appropriate for institutions and dealers to avoid the present disclosure/transparency systems of the exchanges by using NETS? If so, what are theimplications of the exchanges providing a similar facility to meet an investor's desire for anonymity and non-disclosure ? How may it be avoided?

Background

Price discovery is both a process and the outcome of the process.6 Transaction prices in a market are "discovered" as investors with an interest in buying orselling use both the information they have concerning the company as an investment and also the information they have about the present market for its shares.With respect to the market aspect of price discovery, the effectiveness of the process depends on the willingness of the participants (buyers and sellers) toexpress or commit their interests and the availability to the participants of information concerning these interests. The conventions, rules and mechanicssupporting the investor/dealer/exchange for order handling, the Order Book and disclosure of market information have an important effect on the effectivenessand efficiency of price discovery.

For efficient price discovery, the available information must be gathered quickly and presented in usable form at low cost. The effectiveness of the process isproportional to the completeness of the available information, as well as the absence of manipulation and misleading information. Good transparency leads togood price discovery.

Issues

b. Is fragmentation of market information (1994 Paper, pages 66-71) different from fragmentation of markets (liquidity pools)?. If yes, what is the significanceof such difference(s). In coming to a conclusion on this question, please address the following questions:

1) Does it matter to market quality whether the bids and offers entered by participants in a NETS are made public on a timely basis? Is it relevant that such bidsand offers may be available for transactions only to subscribers to a particular NETS?

2) Should transactions agreed to by participants in a NETS be subjected to requirements for timely reporting? To whom?

3) Under what circumstances would the TSE (or other Canadian exchange) be an acceptable agency for timely trade reporting? What are the specific objectionsof NETS or their customers to using the TSE as such an agency?

3. NETS and Reconsolidation of Fragmented Markets

Background

At the 1994 Forum, Professor Lawrence Harris discussed his published paper "Consolidation, Fragmentation, Segmentation, and Regulation."7 In his discussionof segmentation, referred to by him as 're-consolidation of fragmented markets', he reportedly said:

"There are three processes that reconsolidate fragmented markets: (1) traders who will not move their orders from their preferred market segment to anothersegment (instead of moving orders, they merely adjust their orders and respond to information observed in other markets), (2) traders who can move their orderswill route them to the market that provides them with the best prices as long as the improvement in price is enough to get over whatever service preference theyhave with the particular market that they like, (3) arbitrageurs will create new orders to satisfy order flow imbalances across market segments (in effect movingliquidity from one market to another). Each of these processes is a consolidating process or force which tends to bring traders closer together. A fragmentedmarket that is reconsolidated is a segmented market.

For the reconsolidating processes to work, traders must have transparent prices and quotes. Without such information, it would be expensive to find liquidity infragmented markets and arbitrageurs would have trouble moving liquidity from one fragment to another. For the consolidating process to work, broker/clientproblems (such as conflict of interest) must be eliminated. The brokers have to be working for the client; they have to be seeking the best price. Marketsfragment because brokers like to have a private place where they can do their deals. This agency problem has to be confronted when one thinks about marketstructures."8

Professor Harris' observations raise the possibility of reconsolidating markets through the activity of agency traders and arbitrageurs in a highly transparentenvironment with easy access between markets.

Issues

a. Are there circumstances when bids and offers in NETS should be made available to parties outside of the NETS? For example, when the bids and offers are ata better price on the NETS than is available on other markets? Or, alternatively, when a bid or offer has been accepted on a NETS at a price that is inferior tobid/offer prices that are disclosed in other markets that make their information available to the public ("public markets").

b. Should public policy makers be concerned if the "best price" of bids and offers are at superior prices to prices negotiated in a NETS?

c. Should a bidder or offeror on a public market of a better price than the prices on a NETS, be assured of a right to displace a proposed transaction at theinferior price on the NETS?

d. How should bids or offers made in different markets at the same price be treated? In answering these questions: a) consider that it was the publicly availablebid or offer prices that informed the NETS negotiation and b) consider that the public bid/offer was the only or first public expression of interest at this price?

Background

The SEC has recently completed a Rule-making process that aimes at giving investors better prices when they buy and sell by consolidating market informationand tradeable bids and offers ("Order Handling Rules"). The Order Handling Rules emphasize the necessity of improving price discovery in respect of securitiestraded on US exchanges and through Nasdaq. The SEC states that the purpose of these rule changes is "to enhance competition and pricing efficiency in thesecurities markets." The adoption of the Order Handling Rules was announced in SEC Release No. 34-36719, August 29, 1996.

In general terms, new Rule 11Ac1-4 ("the Display Rule") requires certain dealers (over-the-counter market-makers and exchange specialists) to display in thepublic quotation system any customer limit order that is less than block size (10,000 shares) and is at a better price than the dealer's own displayed quotation inthat security or that adds to the size associated with such quote.

The amendment to Rule 11Ac1-1 ("the Quote Rule") subjects to the Quote Rule any market-maker (as defined in the Order Handling Rules) that is responsiblefor more than 1% of a the aggregate trading volume in a security. It also requires market makers to make available for matching any bids or offers at superiorprices that they quote through certain electronic communication networks. This is referred to as the "ECN amendment".

The SEC will deem market-makers to be in compliance with the ECN amendment if the ECN9 provides for the best prices entered into the ECN by marketmakers to be transmitted to an exchange for inclusion in the public quotation system and provides access (for trading) to those prices equivalent to the accesscurrently available to other quotes published by the exchange. In operational terms this has meant that quotations (orders) placed on Instinet by market makersare now available for matching by any broker-dealer via NASDAQ's SelectNet order routing system.

The effect of the ECN amendment is to include in the public quotation/transaction system any order which originates with or is handled by a market-maker wherethe market-maker has caused the order to be widely disseminated on an executable basis through an ECN.

Issues

e. Are rules similar to the Order Handling Rules relevant to the issues regarding fragmentation and/or NETS? If so, please explain.

4. NETS and Integration with Traditional Exchanges

Background

The SC Report discusses 4 models by which the bids, offers and trades negotiated in a NETS could be integrated with the traditional exchanges (pp. 45-54).Total integration with an exchange would mean that the NETS could become simply an order entry facility--perhaps with a particular focus on setting up blockcrosses. Non-integration with an exchange would mean that the only connection between the order books of the NETS and the traditional exchanges would beconducted by arbitrageurs that were participants in both systems.

Issues

a. What is the appropriate degree of integration with respect to: transaction reports, displacement rules, display of bids and offers, tradeability of bids and offersbetween systems?

b. The TSE has identified four models of the Canadian market as it might relate to NETS. Are there any other models or responses that should be considered?Propose a transition from today's model to a model that you would recommend to the Commission.

c. If matters such as centralized reporting (to avoid fragmentation of information) and price and time precedence for orders are important, how should suchgoals be achieved in a fragmented market?

d. In the event that the non-integrated model for NETS is adopted now or in the future how should the goals of liquidity, visibility, price discovery, fairness, andintegrity of the market be achieved (or to what extent should they be achieved)? Or would these goals no longer be relevant by comparison to the gains in thevariety of service vendors that could become available, such as the institutional and block trading departments of member firms? Explain.

5. NETS and Functional Regulation

Background

In the early stages of NETS development, there was considerable discussion about whether such systems and their sponsors should more properly be regulatedas stock exchanges, rather than as brokers (which is how the SEC registered both Instinet US and POSIT). Currently, many regulators question whether this is aproductive discussion. Since NETS have aspects of both markets and brokers, it is felt they should be regulated functionally (see the 1994 Paper pp. 59-60 and76-79).

Issues

a. Should a NETS operating in Canada in Canadian securities be restricted from accepting traditional exchange members and other market intermediaries asusers? What are the implications of the major dealers becoming participants in a NETS that trades in the same securities as the traditional exchanges?

b. Would functional regulation of NETS require that the Commission supervise all NETS directly with respect to prevention and detection of manipulative ordeceptive activity by its users?

c. SEC Rule 17a-23 applies to both NETS and automated dealer systems (NASDAQ stocks, such as those offered by U.S. market-makers, in or as a, "thirdmarket" for listed securities). If dealers offer similar systems in Canada should they be regulated in the same manner as NETS?

6. NETS and Cross Border Securities Regulation

Background

In the present regulatory model, brokers and dealers (securities intermediaries) that provide services to investors are required to be registered with the securitiesadministrator that has jurisdiction over their activities. The securities which are sold to investors must also comply with requirements of the same securitiesadministrator. (1994 Paper pp 79-80). Both NETS and traditional exchanges are able to utilize international communications technology that does not recognizenational borders, which enables easy access to unregistered intermediaries and unregistered (non-reporting) issuers.

Issues

a. How should the regulatory framework address 1) the registration requirements for institutions and market intermediaries using the NETS and 2) reportingissuer status of issuers whose securities are traded on a NETS (1994 Paper, pp. 76-80)?

b. In the event that a NETS provides information and trading services ("Services") in both $US and $CDN, should both the $US and $CDN Services be availablesimultaneously to all subscribers? If not, what would be the implications for the Canadian market of the $CDN Service not being available in certain otherjurisdictions while the $US Service is available to all users globally?

c. How much weight should be put on matters of reciprocity between jurisdictions? Please explain.

d. Should there be restrictions on the securities of foreign issuers that can be traded by Canadians through facilities of a NETS operating in Canada? Shouldthere be restrictions on what types of foreign organizations (e.g. institutions, registered dealers, non-registered market intermediaries) are permitted to becustomers of a NETS for purposes of making bids and offers that will be tradeable by Canadian institutions and market intermediaries via the NETS?

C. The Role of the Commission in Addressing Fragmentation

Issues

1. To what extent is present internal and external fragmentation of markets for Canadian stocks a problem that should be addressed by the Canadian exchangesand/or securities commissions? What, if anything, should be done?

2. If electronic trading systems are permitted to operate independently of an exchange, should the exchanges be compensated for the "public goods" that theyprovide for the capital markets. If yes, on what basis should they be compensated?

3. What impact, if any, should the establishment of electronic trading systems have on self-regulation and the supervision of the markets?