TSE BUYSIDE ROUNDTABLE #4 – OCTOBER 17, 2001

Generally speaking, buy-side concerns focus primarily on market liquidity issues. Market impact costs and execution delay costs, not brokerage fees, are the most significant costs of execution for institutional equity traders. These costs are a direct function of liquidity conditions. The recent rules changes and the proposed new MOC rules do nothing to improve liquidity conditions.

1. The new time-priority rules. While the purpose of time priority rules is quite clear, it seems likely that the implementation will have a negative impact on market liquidity. The new trading engine installed by the TSE is incapable of enforcing client priority rules. As a result, brokers can trade ahead of customers as long as they do not know that a customer order exists. In the absence of a trading engine that can enforce customer priority, anytime a trade occurs ahead of the customer, an infringement of the rule will, rightly or wrongly, be perceived. The impact of the change will ultimately be a reduced willingness by customers to leave orders with brokers and liquidity in the market will be negatively impacted. I suspect that the TSE believes that the new rule requiring brokers to ask permission, if they are aware of customer orders, takes care of the problem and nothing more needs to be done. Is that the case? If so, what additional resources is the TSE planning to devote to surveillance and enforcement of the new rule?

2. Market on Close (MOC) The round-table told the TSE in no uncertain terms that any MOC proposal that does not guarantee a fill is unacceptable. Such a proposal, even as a short-term fix, would, without question, fail because the very rationale for MOC is the need for a fill at the closing price. The TSE's difficulties in arranging guarantors will necessarily lead to delays in delivering a new MOC product. This is probably a good thing. The proposal currently on the table is really a patchwork of current market practices characterised by volatile closings on thin volume and extremely questionable if not objectionable behaviour of some market participants. Perhaps the TSE might instead now take the time to seriously consider a Dutch auction process at the end of day to determine the closing price and fill MOC orders. A Dutch auction should be managed by the TSE and open to all market participants. Since the auction process is completely anonymous, brokers could of course participate without contravening client priority rules. (As in 1. Above) A guarantor for the process would not likely be required because a market price will be found to satisfy demand or supply imbalances. The TSE should broadcast imbalances during the last half-hour of the regular trading day. Participants would put in their best prices, knowing they will receive the price that was required to clear the market. In event of a failure to clear the market, the imbalance could again be broadcast and the auction process repeated until a closing price that clears the market is generated. There will be a price determined by the market in the market that will clear the market. It would be an inclusive system, which could draw on the resources of all TSE participants. By drawing on the liquidity of the market and not the limited capital of a selected few, a more pure market price could not be generated. Is the TSE willing to make a commitment to explore this option more completely?

Gregory H. King, Director, Operations and Trading
CDP Global Asset Management