IIROC issues draft guidance on locked and crossed markets

IIROC has issued a request for comments on proposed guidance on locked and crossed markets. A market is "locked" when a bid is entered on one marketplace at the same price as an offer on another marketplace, or an offer is entered at the same price as a bid. A market is "crossed" when a bid is entered at a higher price than an offer on another market, or an offer at a lower price than a bid.

Markets may be locked or crossed for any number of reasons, including different latencies in various order entry and market data systems (such that the person entering the order doesn't see the order in another market entered a split second earlier). However, one incentive to lock or cross a market is rebate arbitrage, where a trader will enter a passive order hoping to entice the order on the other side of the lock or cross to trade with it. The strategy is used to take advantage of the practice of many markets to pay a fee to liquidity providers (passive orders).

Intentionally locking or crossing a market is a violation of section 6.2 of National Instrument 23-101.

The draft guidance provides examples of situations IIROC considers acceptable and unacceptable. IIROC does not view a lock or crossed market to be intentional if

• race conditions existed where orders are entered on different markets at essentially the same time,
• the lock or cross is due to the latency of the system(s) used,
• there was a malfunction or material delay in the system(s) used, or
• a "bypass" order (an order to take out the visible orders at better prices on other markets when entering a cross outside the national best bid and offer) bypasses undisclosed liquidity at better prices that is exposed immediately after the entry of the order.
  

A market may be locked (but not crossed) if the person entering the order is required to enter it on a particular market. For example, if a security is subject to resale restrictions under the SEC's Regulation S, it can only be resold in a "designated offshore securities market" under that rule. Currently only the TSX, the TSX Venture, CNSX and Pure Trading are designated, which means that an order could be entered on one of those markets that locks with a non-designated markets. Although the notice is silent on the point, presumably an order could not be entered on Pure Trading that locks with the TSX.

The notice also clarifies that a person who has properly entered an order on a market that subsequently becomes locked because of an order entered on another market is not obliged to remove the order and enter it on the other market. It further clarifies that locking or crossing a market for the purpose of rebate arbitrage is not permitted.

The guidance is open for comment until May 25, 2010. Comments should be directed to James Twiss, Vice President, Market Regulation Policy.