May 2013

Heart of Darkness
A data driven analysis of the Canadian Dark rules.

May 2013
Recently, a variety of global pundits have seen fit to weigh in on the impact that new dark pool and dark liquidity rules have had on the Canadian equity markets. While the comments are varied in tone and commentary, they have all had one common theme: a lack of solid data on which to base their conclusions. As the leader in data driven market structure analysis, we have taken up the cause and offer up the following analysis of the dark rules and their impact on the Canadian market place. We should make it very clear at the outset that our conclusion is that there is little to no evidence that new dark rules significantly impacted trading costs or market quality since their implementation last October. We will walk the reader through the analysis we have done to arrive at our results. We will then consider the impact the rules have had on cost of participating in the Canadian equity markets. In order to (at least partially) limit the impact of exogenous factors, we normalize all results by comparing to similar U.S. market metrics. The metrics we have chosen to examine are market volatility (both real and implied), market volumes, bidoffer spread and finally peer group transaction costs (T-Cost). First, we look at implied volatility by comparing the VIX index to the VIXC (S&P/TSX 60 Implied Volatility) index. As is clear in the chart below, these two indices mirror each other and no significant change occurred to that relationship leading up to or immediately following the implementation of the dark rules. (For all Charts Canada will be in Red and the U.S. in Blue). It has been suggested, most notably by a consortium of U.S. equity exchange operators, that Canadian volatility is down significantly since the dark rules took effect. While that statement is technically true, the chart below highlights that U.S. volatility has also taken a similar path. Unless we believe that rules surrounding dark trading in Canada have somehow impacted U.S. volatility, we must conclude that the reduction of Canadian volatility has not been caused by the dark rule implementation.

Implied Volatility (Source Bloomberg) 30 25 20 15 10 5 0

VIX Index

VIXC Index

We next look at the real volatility of the S&P 500 Index and the S&P/TSX Composite Index using value-weighted trades. Interestingly, US volatility fell more than Canadian volatility, between Dec-2012 and Jan-2013. However, the CAN/US volatility ratio has since returned to levels found during Aug to Nov-2012; we find it difficult to argue for causality between the new rules and volatility. Real Volatility (Source ITG) 3% 1.00 0.95 Volatility 2% 0.90 0.85 0.80 1% 0.75 0.70 0% 0.65 CAN/US Volatility Ratio
2

S&P/TSX Comp Real Volatility

S&P500 Real Volatility

Volatility Ratio

We now consider volumes for the S&P 500 versus the S&P/TSX Composite indices (rolling 5d average). We use the large indices rather than universal volumes to limit the impact of smaller non-index names particularly in Canada where such names can grossly distort overall volumes. While there is plenty of volatility on a week to week basis, the S&P 500 volumes have been ~34.5 times those of the Composite for most of the last year, and no significant shift can be found, in either direction, immediately following the dark rule implementation. ITG continuously monitors the portion of trading on Canadian / U.S. interlisted names that transact in both markets. While there has been some volatility around this metric, it is well within historical limits. We tend to see the U.S. portion of interlisted trading rise as

volatility rises. Our best hypothesis for this phenomena is that most of the options trading on these listings occur in the U.S. and the related delta hedging is largely captive to U.S. equity markets. The delta hedging activity is larger during higher volatility regimes, leading to a greater portion of trading in the U.S. equity markets on the interlisted names during periods of high volatility. Volume (Source Bloomberg) SP500/TSX Comp Ratio CAN/US Spread Ratio
3

1200 1000 Shares (MM) 800 600 400 200 0

5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

S&P/TSX Comp Volume

SP500 Volume

Volume Ratio

We next examine the value-weighted trade spread for both the S&P 500 and the S&P/TSX Composite. The spread for both indices had been trending down leading up to th October 15 and has continued to do so since that time. The ratio of the two numbers has been close to a flat line, suggesting that the dark rules havent had any impact on quoted spread. If anything, Canadian spreads have been more volatile than U.S. th spreads since October 15 . We also studied the depth of book at the NBBO and see no significant change in Canadian depth since the rule implementation. (Note that Canadian spreads are historically much larger than U.S. spreads, partially due to the fact that the value-weighted average price of an S&P500 stock is roughly 3 times higher than that of the average S&P/TSX Composite index stock but they share a similar 1 penny minimum tick size). Quoted Spread (Source ITG) 100 20 18 16 14 12 10 8 6 4 2 0

Spread (bps)

10

S&P/TSX Comp Spread

S&P500 Spread

CAN/US Spread Ratio

Lastly, and most interestingly, we looked at transaction cost (T-Cost) using ITGs pretrade cost model and proprietary peer group data base. For this metric, we compare the trading costs for a $500 million basket of the S&P 500 versus a similar basket for the S&P/TSX Composite Index using a VWAP implementation. We are in a unique position to estimate this cost, as we are able to calibrate our pre-trade model using our peer group data base which is the largest such data base on the planet, both in terms of value traded and breadth of clients contributing. Both markets see a small uptick in costs since October 15 , but in each case the uptick occurred months after the rule was implemented. We do not see any impact to the relationship of the two cost lines at, or around, the rule implementation. Transaction Costs (Source ITG) 35 30 T-Cost (bps) 25 20 15 10 5 th

S&P/TSX Comp T-Cost

S&P500 T-Cost

For comparison, after IIROC started assigning a regulatory fee to message traffic, we saw immediate significant changes to various metrics including order to trade ratios, depth at the NBBO and spread. In that case there was a very clear impact on the market resulting from the new regulation. While it is less satisfying to do this style of analysis and find no evidence of change, we believe that the correct conclusion is that the dark rules have not had a noticeable impact on trading costs in Canada for the average user. It may be the case that some strategies are winners and some are losers, but the aggregate trading performance was not impacted as a result of the change. Having clearly demonstrated that market quality and trading costs have not been significantly impacted since the dark rules were implemented, we move on to considering the other costs that dark rules may have. We do this by examining the impact of the new rules on exchange fees. Prior to the new rule implementation, Alpha IntraSpread had a market share of ~ 4.5%. As the market most impacted by the rule, IntraSpreads market share dropped to ~0.3% the very day the rule took effect. This is meaningful for two key reasons. First, because the active fee on IntraSpread was 4 mils per share versus 28 mils on the Alpha lit book. Most of Intraspreads flow subsequently migrated to Alphas lit book. Second, the active side of all IntraSpread trades was the retail client and most of the impact was felt by the retail dealers. If we consider recent trading volumes which are somewhat lower than last October, we conservatively expect IntraSpread to trade ~ 325 million shares in April 2013, rather than just under 40 million shares. The retail brokers paid an extra 24 mils on some 280 million shares last month. This results in an annualized increase in active trading fees of roughly $9 million. Using a variety of data
4

sources, including IIROCs HOTT study, we can comfortably conclude that greater than 50% of the passive flow interacted with high frequency prop strategies. HFTs gain in this scenario, as their passive rebates skyrocket from 0 on IntraSpread to 24 mils on Alpha (or even 29 mils on TSX). At days end, the retail brokers have seen an annualized trading cost increase to the tune of $9 million, the HFT community has gained a passive credit windfall of just under $4 million. While these increased exchange fees may appear inconsequential to some, one must consider that IntraSpread was effectively castrated in its infancy and unable to grow in a SM manner that would have increased the cost efficiencies. Likewise, while Match Now did not see the catastrophic market share decline that IntraSpread experienced, it is reasonable to suspect their growth since October has been slower than would otherwise have been the case and thus, they too have not been able to deliver as much savings to retail brokers due to this rule. Further if such a rule were to be implemented in the U.S. markets, where dark trading is far more mature, we expect the exchange cost impact would be a large multiple of that seen in Canada.

Conclusion
Our analysis very clearly demonstrates that no discernible improvements to market quality nor market impact costs have arisen from the new Canadian dark liquidity rules. However these rules have placed increased exchange costs on the dealer and institutional investor communities, while rewarding the High Frequency Traders with increased passive rebate opportunities. Beyond this, the street has spent tremendous time and resources to reprogram their algorithms and smart order routers to ensure they comply with the new rules. While pundits around the globe have hailed the new Canadian rules as the panacea of market structure, a serious analysis of the data leaves us far from convinced. The dark rules have limited the trading options available to professional traders charged with a best execution obligation, and done nothing to improve overall market quality or reduce market impact costs. The benefits of the new rules have been largely enjoyed by the lit exchanges and their favoured high frequency clientele, with no demonstrable upside for natural investors or reduction in systemic risk. We urge regulators around the globe to carefully consider our analysis before rushing to duplicate the Canadian rule set. We would also encourage all those commenting on the impact of any newly enacted regulation to consider our approach, and control for exogenous factors wherever possible. Informed market structure debate is a good thing, but debate that is informed by bad data is both dangerous and distracting.

ITG CANADA CORP The Exchange Tower 130 King Street West, Suite 1040 Toronto, Ontario M5X 1B1 RESEARCH Doug Clark Chad Dale Dora Lee, MASc Ivan Cajic Alex Chan Jiaqin (Jay) Jin SALES Dave Harris Etienne Phaneuf Mike Barclay Andy Seto Jay Patel Joanne Hill Wendy Stock Kelly Ashbee Earl Cummings Clayton Rego David Beveridge Matthew Wigle TRADING Ian Williams, CFA Mark Armstrong Jeff Gamble Jeff Hortogianni Ken Latvanen Dave Rogers Brent Siemens CLIENT SITE SERVICE Vishen Maharaj Michael McConkey Rod Akins Michael Speirs Maria Ma Morgan Wingfield Director, Client Site Service Vice President, Trading Systems Assistant Vice President, Client Site Service Assistant Vice President, Client Site Service Assistant Vice President, Trading System Administrator Assistant Vice President, Trading System Administrator (416) 874-0849 (416) 874-0770 (416) 874-0770 (416) 874-0770 (416) 874-0770 (416) 874-0770 Managing Director, Sales & Trading Managing Director, Sales & Trading Director, Sales Director, Sales Director, Institutional Equity Research Sales Vice President, Sales Vice President, Sales Vice President, Technology Relationship Manager Director, Product Management Director, Product Management Vice President, Product Management Vice President, Product Management (416) 874-0731 (416) 874-0730 (416) 874-0739 (416) 874-0867 (416) 874-0738 (416) 874-0734 (416) 874-0722 (416) 874-0715 (416) 874-0668 (416) 874-0733 (416) 874-0681 (416) 874-0868 Trading Desk Phone Fax (416) 874-0700 (416) 874-0900 (416) 874-0690

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The opinions expressed herein are those of the writer and do not necessarily reflect the opinions of ITG Canada Corp. This report has been prepared solely for informational purposes only and is not intended to provide financial, legal, accounting or tax advice and should not be relied upon in that regard. Information provided in this report is believed to be accurate and reliable, but we cannot guarantee it is accurate or complete or current at all times and no representation is made in this regard. Conclusions and opinions do not guarantee any future event or performance. ITG Canada Corp. is not liable for any errors or omissions in the information or for any loss or damage suffered. Although the information contained in this report has been obtained from sources that ITG Canada Corp. believes to be reliable, we do not guarantee its accuracy, and as such, the information may be incomplete or condensed. All opinions, estimates and other information included in this report constitute our judgment as of the date hereof and are subject to change without notice. ITG Canada Corp. will furnish upon request publicly available information on which this report is based. MATCH NowSM is a product offering of TriAct Canada Marketplace LP (TriAct), member CIPF and IIROC. These materials are not intended to be used for trading or investment purposes or as an offer to sell or the solicitation of an offer to buy any security or financial product. No guarantee or warranty is made as to the reasonableness of the assumptions or the accuracy of the models or market data used by ITG Canada Corp. or the actual results that may be achieved. ITG Canada Corp. is not a registered investment adviser and does not provide investment advice or recommendations to buy or sell securities, to hire any investment adviser or to pursue any investment or trading strategy. All information, terms, and pricing set forth herein is indicative and based on, inter alia, market conditions at the time of this writing and are subject to change without notice. 2013 Investment Technology Group, Inc. All rights reserved. Not to be reproduced or retransmitted without permission. #<<52113-17895>> Broker-dealer products and services are offered by: in the U.S., ITG Inc., member FINRA, SIPC; in Canada, ITG Canada Corp., member Canadian Investor Protection Fund (CIPF) and Investment Industry Regulatory Organization of Canada (IIROC); in Europe, Investment Technology Group Limited, registered in Ireland No. 283940 (ITGL) and/or Investment Technology Group Europe Limited, registered in Ireland No. 283939 (ITGEL) (the registered office of ITGL and ITGEL is First Floor, Block A, Georges Quay, Dublin 2, Ireland and ITGL is a member of the London Stock Exchange, Euronext and Deutsche Brse). ITGL and ITGEL are authorised and regulated by the Central Bank of Ireland; in Asia, ITG Hong Kong Limited (SFC License No. AHD810), ITG Singapore Pte Limited (CMS Licence No. 100138-1), and ITG Australia Limited (AFS License No. 219582). All of the above entities are subsidiaries of Investment Technology Group, Inc. MATCH NowSM is a product offering of TriAct Canada Marketplace LP (TriAct), member CIPF and IIROC. TriAct is a wholly owned subsidiary of ITG Canada Corp. Standard & Poor's and S&P 500 are trademarks of the McGraw-Hill Companies, Inc. All trademarks, service marks, and trade names not owned by ITG are the property of their respective owners.