The Curious Case of Missing Equity Volumes

January 11, 2016 Doug Clark
A glance back

On January 12 last year, the TMX Group made significant changes to its Market on Close (MOC) facility. The revamped closing auction was implemented to address longstanding concerns of price protection and the inability to execute odd or mixed lot orders. A quick refresher on the changes that went into effect early last year:

  • Introduction of odd and mixed lot order into the MOC facility.
  • Ability to enter Limbit on Close (LOC) orders from 7:00am until 3:40pm.
  • The published 3:40pm auction imbalance only considers MOC orders and marketable LOC orders.

Around the same time, as part of the 2015 Federal Budget, the government introduced new tax rules to address the dividend rental strategy that granted tax advantages for Canadian dealers engaged in synthetic equity arrangements with tax indifferent entities. The new measures applied to dividends that were paid or became payable after October 2015.

At a high level, the strategy is quite simple. A Canadian dealer purchases a basket of equities from a tax exempt entity. A synthetic equity arrangement is orchestrated whereby the dealer and tax exempt entity enter into a total return swap which grants a long position to the tax exempt entity and a short position to the dealer. The dealer receives the tax-free dividends and maintains a fully hedged position, while the tax exempt entity retains its portfolio exposure. In return, the dealer pays the tax exempt entity an incentive fee.


Apart from the incentive fee, the tax exempt entity benefits from the influx of cash which can be used to invest in other strategies or to earn the risk free rate of return. Additionally, since the index exposure is achieved synthetically, during index rebalances the entity need not trade the underlying securities thereby saving on transaction costs.

One of the negative implications of the strategy however, is that it creates a perverse incentive for the dealer to run up the close on rebalance days. Because the tax exempt entity is benchmarked to the close, any outperformance the dealer attains is pure profit. And perhaps best of all, there would not exist a profit sharing agreement so the dealer could keep 100% of the profit. This means that the dealer directly benefits if it arbitrarily influences the last tick of the day.


We have had an opportunity to observe the consequences of both the new tax laws and the revamped MOC facility for more than 9 months, particularly the facility’s effect on index rebalance days when the closing auction is utilized the most. Although the sample size is small and it would be reckless to draw any conclusions, we present a few observations and some hypotheses.

Volume Trends

With the elimination of the total return swap dividend rental trade, we anticipated volumes to return to the equity market in place of the synthetic swap-related volume. Institutional investors who have historically achieved their index portfolio exposure through total return swaps would now, perhaps, be required to hold and trade the underlying securities of their portfolio. As a consequence, we expected to see volumes increase during index rebalances.

It is somewhat surprising, however, that this has not been the case. In fact, quite the opposite is true: MOC volumes on index rebalance days drastically declined last year.


Part of this volume decline can no doubt be attributed to investors’ increased usage of the new Limit on Close features. With the increased flexibility, indexers can now exercise more control over their orders without remaining entirely reliant on the MOC session.

Performance Trends

Historically, executing a rebalance trade with a 1-day VWAP usually outperformed the close. This was especially true for TSX 60 funding trades. Between 2010-Q1 and 2014-Q4, before the implementation of the new MOC facility, the full day VWAP outperformed the close price by 48bps on average for the TSX 60 and by 5bps for the TSX Composite.

Since the implementation of the new MOC facility, there has been a reversal in the trend. Across the three quarterly rebalances we’ve observed thus far, the full day VWAP has on average underperformed the close by -34bps and -81bps for the TSX 60 and TSX Composite, respectively. What is the cause of this phenomenon? We theorize that indexers have become savvier in using the Limit on Close features in the new MOC facility. Where indexers were previously handcuffed to the close price without control over their orders, they are now able to execute their trades more strategically by layering their orders and specifying maximum price thresholds before the 3:40pm imbalance. This also means that indexers could opt to not participate in a volatile MOC session which may help explain away some of the MOC volume decline.


As a result of the last several quarterly rebalances going wrong way (sells outperformed buys) and dealers engaged in risk bids losing money, we believe that there has been a decline in risk bids during recent rebalances. This has placed further control of the trade in indexers’ hands. Until the historic norm of right way closes returns, we could see a further decline in risk bids in the future.


Throughout the past several months, we have seen swaps unwinding, probably due to the elimination of the dividend rental strategy. However, is it possible that equity volumes have not returned simply because institutional investors receiving synthetic portfolio exposure continue to do so? The lack of equity volumes led us to investigate alternate derivative instruments that could achieve the same outcome and provide similar economics.

Upon investigating recent trends in the Canadian futures market, specifically SXF (S&P/TSX 60 Index Standard Futures), we discovered some surprising results. There is strong evidence to suggest that the dividend rental trade has evolved and migrated to the futures market. Suppose the following strategy:

  • A Canadian dealer purchases a TSX 60 equity basket from a tax exempt entity.
  • The dealer then hedges its position by maintaining a short of the TSX 60 future.
  • In the meantime, the tax exempt entity achieves its index exposure by purchasing the TSX 60 future.
  • During contract expiry, the dealer sells the futures roll (buys the current contract and sells the deferred contract) while the tax exempt entity purchases the roll (buys the deferred contract and sells the current contract)

Towards the second half of the year, there was a sudden rise in futures open interest to levels not seen since 2007. Although volumes have been virtually flat for the past 8 years, there is a noticeable spike in the latter portion of last year. If the dividend rental trade has indeed migrated to the futures market, one would expect volumes and open interest to increase as a direct consequence.


During the same period, we observed a widening of the spread between the current and deferred contracts. Traditionally, when financing costs exceeded the receipt of expected dividend income, deferred index futures traded at a premium to the active contract; however, in the past several years with interest rates at all-time lows, deferred index futures have traded at a discount to the active contract. Towards the second half of last year, this discount has widened even further. We theorize that dealers have been deliberately selling the deferred contract below fair value as a form of incentive payment to the tax indifferent entity. During the September 2015 futures expiry, the SXF roll traded at a discount of 37bps to fair value compared to a discount of only 12bps in the same quarter last year.


Furthermore, last year on August 12, the Montreal Exchange announced an amendment to the rules of the Bourse in order to eliminate position limits on the S&P/TSX 60 futures (SXF). This change enables dealers and their counterparties to amass a position of limitless size in SXF, which would no doubt be required given the size of these trades. The new rule came into effect right around the time that swaps began to unwind and the new dividend rental strategy went live.


What are the implications of this new market landscape that has new rules, new strategies and a new market on close facility? It is certainly an exciting time in equity market structure and there is an opportunity to take advantage in this dynamic environment.

For natural investors, the apparent migration of the dividend rental strategy to the futures market and consequent cheapening of the roll is an opportunity to gain exposure to the S&P/TSX 60 at a low cost.

As a result of the new MOC facility, volatility around the close on index days has declined and natural indexers have experienced less wealth erosion. With the last few Canadian S&P rebalances closing wrong way (sells outperforming buys) and dealers who provided performance guarantees inevitably losing money, we may see a decline in capital commitment from dealers in the future.

We continue to monitor changes in our evolving market structure and will continue to conduct analysis to provide our partners with unique insights and a better understanding of the complex marketplace.

  • Doug Clark

    Managing Director, Head of Research, Canada