Despite a decade of advances in technology, trading strategies and ownership, Canada’s equity marketplace seems to be in about the same place it was a decade ago: fragmented, pricey and riven with conflicts of interest. And the irresistible progress of technology is partly to blame.
That’s the view from the Toronto Stock Exchange.
“We’re at the centre of a tremendous amount of change that’s going on in stock markets,” says Kevan Cowan, president of TSX Markets. He faces alternative trading systems (ATSs) such as Alpha, Omega and Chi-X that have gained momentum—and market share—in the past year.
“We’re battling various letters of the Greek alphabet,” Cowan quips.
That was then
In 1999, there were five equity exchanges in Canada. Trading was costly, and stock brokers owned the exchanges. Then the exchanges signed an agreement to specialize—an agreement that would have ended this year—with Toronto taking on large-cap issues, Montreal focusing on derivatives and Alberta, Vancouver and Montreal splitting the small-cap market.
Alberta and Vancouver merged to form a small-cap exchange that quickly took in the Winnipeg exchange.
Toronto soon bought the small-cap marketplace, and it demutualized, becoming a public company. Montreal followed in demutualizing. TSX Group bought it in 2008. But the consolidation advantage was short-lived.
ATSs had been approved by the regulators in 2001, but there was relatively little interest in the Canadian marketplace, outside of fixed income, until about two years ago. Since then, a number of competitors to the TSX have emerged.
“The trading world has been turned upside down,” Cowan says. But with the new competition, “we’ve come full circle.”
This is now
He’s forthright about how the trading universe has come full circle. ATSs have brought in their wake market fragmentation. Trading fees have fallen, but the technological costs to keep track of multiple marketplaces—and the best prices—have risen. Instead of greater liquidity, all the marketplaces, the TSX included, are mostly carving up the same pie—one, however, that is growing as foreign investment dealers pile into Canada’s energy and mining listings. Promises of customer-friendliness have given way to customer confusion.
That places new burdens on institutional investors—pension funds and mutual funds—to monitor in which marketplace they are transacting. “More than ever,” Cowan says, “it’s incumbent on traders and service providers to work hard to find best execution.”
There are other challenges for institutional investors. One is high-frequency trading. Traders with cutting-edge algorithms, the best connectivity to a marketplace and the quickest computers are able to scout out prices and swoop in before the market can react.
An index of that activity is the order to trade ratio, Cowan suggests. At the beginning of 2005, there were roughly 13 orders (or messages) for every trade that was actually executed on the TSX. Now, the ratio of orders to trades is more than 40.
Cowan defines high-frequency traders as those who make more than 10 orders for a single trade. “Only a small proportion of those, depending on the strategy of the trader, will actually hit and result in an execution,” he explains. But those trades represent 20% of the daily volume in Canada, and 66% in the U.S.
Not your grandma’s trader
High-frequency trading has also set a record high (or low) for holding periods: on average 8 seconds.
“The game has completely changed. What we see now is that the trading shops and trading platforms south of the border are almost entirely based on mathematicians and engineers and Ph.Ds. It’s no longer the traditional type of trader,” Cowan says.
High-frequency traders come in three colours. Some use algorithms to take advantage of short-term market fluctuations. Some are replacing traditional market-makers by taking on both sides of a trade, eking out profit through high volumes of low margin transactions. And some engage in rebate-trading.
Rebate-trading was made possible by changes in 2006 in which exchanges no longer priced buy and sell orders the same way. In the maker-taker system, those who post offers—the “makers”—receive a rebate for providing liquidity. Those who “take”—those who buy the stocks—pay the cost of the transaction. It’s not necessarily a profitable trading model, Cowan, notes; the London Stock Exchange has gone back to the traditional model of an equal tariff on both sides of the trade.
Still, the rise of electronic trading, with average trade sizes falling from 1800 shares to 600 shares over the past decade, signifies a decline in block trading. That has left institutional investors, who seek to move large blocks of shares, two choices, or rather two technological choices over the traditional ones.
Where once a trader would work a large order, buying or selling shares in the market, now institutional investors can have their traders use algorithms that break large orders into smaller ones based on the average volume in the market, for example. Smaller orders disguise their intentions and so lower market impact costs, i.e. the feeding frenzy when large orders become public.
The second option revolves around having a trader work a large order on the upstairs market, trying to match buyers and sellers over the telephone. But now, an institutional investor can electronically enter orders into a “dark pool”—a subscriber-only marketplace.
That’s useful for institutional investors who want a quick fill on their orders, but it inhibits price discovery in public marketplace, since those trades are only reported after the fact.
Cowan says that some may think that dark pools are the electronic version of upstairs trading. But, he thinks that ATSs should be held to a higher standard than those that apply to an upstairs trader at a brokerage firm.
All the same, he admits that stock trading is increasingly commoditized. So ATSs, along with the TSX, have to offer something more than just a trading place.