Background

The evolution of the Canadian equity market has significantly affected the way in which orders are executed.  Changes in market structure have resulted in a more complex trading environment and give rise to new trading dynamics.  These changes include:

• the introduction of multiple marketplaces;
• the increased prevalence of high speed/high frequency electronic trading;
• increased order to trade ratios, and the corresponding increase in message traffic;
• smaller average execution size; and
• possible periods of increased market volatility.1

In this increasingly fast-paced environment, the type of orders used can materially impact the quality of trade execution.  A Participant must appreciate that, based on prevailing market conditions in the context of the current market structure, a particular order type may function as designed but the execution outcome may result in an unanticipated price.  Of particular concern are order types without specific execution price limits, such as a “stop loss order” placed without a limit price.2  During periods of liquidity imbalances or fast moving markets, there is heightened risk that an order to sell or buy “at any price” will result in an inferior quality execution.  For this reason, Participants are encouraged to place a limit on the execution price of a stop loss order wherever possible.

Questions and Answers

The following is a list of the “most frequently asked” questions regarding the use of certain order types in the context of recent developments in Canadian market structure and the response of IIROC to each question:

1. Should market orders or limit orders be used in today’s more complex markets?
   
   The answer to this question depends on what is most important to the client.  If certainty of execution is comparatively more important to the client than the price at which the transaction is effected, a market order may be an effective way to quickly buy or sell a security, as a market order will usually be executed immediately at the best available price.  However, there is no control over what the best available price will be at the moment the trade is executed and the corresponding cost of the transaction.  In cases of extreme market volatility or liquidity imbalance, the market price can quickly drop below or rise above the price that was quoted at the time the order was entered and a market order may trade at a price which is significantly different from the expected execution price or range of prices.  During times of very high market activity, there may be delays in message traffic with quotes lagging behind actual prices that continue to change on marketplaces in real time.  The size of any quote may change rapidly, affecting the likelihood of a quoted price being available in whole or in part.  If a market order is entered before the opening of any marketplace, the execution price will reflect all other orders, including any other market orders, which have been entered taking into account developments since the close of the marketplaces on the previous trading day.
   
   In contrast, a limit order provides control over the execution price but also reduces the certainty of execution.  It is possible a limit order will not be executed, missing the opportunity to buy or sell the stock altogether in a fast moving market.  Aggressively priced limit orders, when a buy limit order has a higher price than the prevailing market and a sell limit order has a lower price than the prevailing market, will trade much like a market order but the order will not “chase” the market price and potentially execute at a price which is outside the range which is acceptable to the investor.
2. Does a “stop loss” order prevent losses in fast moving markets?
   
   Not necessarily.  A stop loss order without any limit on the price of execution will, once the market has reached the pre-determined trigger price, be entered on a marketplace as a market order.  Furthermore, the execution of stop loss orders can exacerbate a selloff trend by increasing the liquidity imbalance, given that stop loss orders tend to cluster at or around certain trigger prices.
   
   A stop loss limit order which, when triggered, is entered as a limit order, can be used to restrict downside risk.  As with all limit orders, there is no guarantee that the order will be executed following entry on a marketplace.  However, a stop loss limit order prevents executions at an unanticipated price.  Once booked, the limit assigned to the order can be managed to better control the execution of the order.  In a volatile market, a stop loss limit order may not be executed, in which case the investor will continue to be exposed to a declining stock price (but the investor will not receive an execution price which was otherwise unanticipated).  While there is no guarantee of execution when using a limit order, the use of this order type may provide an opportunity for participation in a recovery in the event of a short term fluctuation in the price of a fast moving stock.
3. Can “All or None” orders be used to guarantee a fill of an order at a specific price in volatile markets?
   
   No.  An “All or None” order is a special terms order for the purposes of UMIR and, as such, it does not participate in the “regular” market.  Not all marketplaces or Participants support or accept “All or None” orders.3 An “All or None” order is executed on a best-efforts basis and ranks lower in priority to orders without special conditions.  This order type requires that the total number of shares specified be filled in a single transaction, at the limit price or better on a marketplace having a sufficient volume of the stock at the best price.  Since its execution is dependent upon there being sufficient available volume of the security on the best market that offers this order type, the security may trade at or through the price of the “All or None” order without the order being executed.  An “All or None” order will remain open until it is executed or cancelled. 
   
   An alternative to an “All or None” order is a “Fill or Kill” order which also must be filled entirely at the limit price or better, but is cancelled if the order is not immediately executed.  A “Fill or Kill” order can be used to detect liquidity quickly on any marketplace but does not guarantee that the order will be filled at the limit price in a volatile market.
4. Is there any order type that can ensure that a trade of an Exchange-traded Fund (“ETF”) occurs near its net asset value in volatile markets?
   
   No.  ETFs trade like stocks and must match buyers to sellers.  However, an ETF is a listed mutual fund that holds securities of an underlying index or other basket of securities.  In order for ETF trading to reflect fair prices, the prices of the ETF’s underlying holdings must be stable and readily calculable.  This stability may not exist during periods of heightened market volatility, which may hinder the process of accurately pricing ETFs.  In instances when ETF quotes are subject to significant market volatility, a market order can result in a fill at a price which differs significantly from the price that was quoted at the time the trade was entered or the net asset value of the ETF at the time of the execution of the trade.  Placing a “stop loss” order without a limit also poses the same risk of getting filled at a price which differs significantly from the “stop” price trigger.  A limit order or stop loss limit order are alternatives that can limit losses, if the orders can be filled in a volatile market.  If the market is missed with the limit order, this also provides an opportunity to hold the position and take advantage of any recovery in the value of the ETF which has an intrinsic value based on its holdings.

• 1For example, see IIROC News Release “IIROC announces results of regulatory review of May 6 trading in Canadian equity marketplaces” (September 9, 2010).  The review was undertaken to understand the causes of these sudden price declines and recoveries in Canadian equity marketplaces during the so-called “Flash Crash” on May 6, 2010.
• 2Analysis conducted by IIROC regarding the market events of May 6, 2010 indicated that “On-Stop Market Orders” contributed to the rapid market decline.  The execution of these orders, in some cases, resulted in fills at drastically lower prices than expected; notwithstanding that the orders functioned as designed.  Reference should be made to the report prepared by IIROC entitled Review of the Market Events of May 6, 2010 available on the IIROC website at www.iiroc.ca.
• 3See Summary Comparison of Current Equity Marketplaces (Table 3 – Marketplace Provisions for Order Types) available on the IIROC website at www.iiroc.ca. Both the Toronto Stock Exchange and TSX Venture Exchange have eliminated this order type effective December 15, 2008 but the order type is supported on Alpha trading Systems, Chi-X Canada ATS Limited, Canadian National Stock Exchange and Omega ATS Limited.