New entrants create compliance hurdles for traders
2007-09-04 16:21 ET - Street Wire
by Stockwatch Business Reporter
The Canadian securities industry is finally noticing that recent trading technology will make trading quite different. At traders' conferences across the country, Canadians talk about new exchanges, new rules and new headaches, while the Americans, like an older brother, smile at the commotion after going through the same turmoil themselves years earlier.
New competitors are turning up all over the place to challenge the TSX monopoly on equities trading in Canada. Examples include Liquidnet, Pure Trading, Blockbook and Match Now, as well as the upcoming Instinet, Alpha and Omega. This bewildering array makes finding the best price for a client much more difficult than checking the latest bids on the Toronto Stock Exchange.
According to Market Regulation Services Inc., Liquidnet, a "dark pool," for institutional investors run by Seth Merrin, is the largest alternative trading system (ATS) by dollars in Canada as of July 7, 2007 -- which translates to 0.105 per cent of the market. A dark pool connects buyers and sellers -- Liquidnet caters to institutions -- that want to trade directly and anonymously.
Pure Trading, a visible auction market similar to the TSX, and which plans to list the same stocks, will commence business on Sept. 14. It will list three stocks for the first few weeks, to let dealers and vendors work out any problems they have using the market, then start listing more stocks some time in October.
Alpha is an ATS backed by the six Canadian banks and Canaccord Capital Inc. Information is scant, but it appears Alpha will connect with all the exchanges in Canada to ensure that orders are made without breaking best execution and best price rules.
Alpha and Omega are unrelated. Omega is an ATS slated to start in the fourth quarter of 2007. It is backed in part by Perimeter Financial Corp., which also runs Blockbook, another Canadian dark pool designed for institutions.
Ian Bandeen, the chief executive officer of Pure Trading, says competition will increase the overall trading volumes on Canadian exchanges. It will allow traders to use sophisticated computer algorithms to fill large orders, bringing liquidity out of the upstairs market into the open. These algorithms do not work as well when there is only one exchange. Judith Robertson, an executive vice-president at Perimeter and the founder of Blockbook, says, "Trades that were too scary to hand to a broker might be possible now."
While the situation is new for Canada, it is already a reality in the United States. Michael Kustra, the head of Morgan Stanley's West Coast electronic trading, explains that there are about 40 places to trade stocks in the U.S., counting every ATS, ECN (electronic communication network), broker pool and dark pool. All you need to run an exchange now are servers, and collecting trading fees is easy.
If Mr. Kustra did not have computers to do most of the legwork for him, keeping up with all the rules would be impossible. For example, U.S. regulations oblige a broker to take out the best displayed bid or ask before trading in dark pools. With so many exchanges, it takes time to figure out where that quote is, which is why Morgan Stanley has a smart router do it.
Regulator-mandated connections between the exchanges in the U.S. allow them to check each other for a better price before allowing a trade. That system is slow. Morgan Stanley, which keeps tabs on all the exchanges, has price information already and can check much faster. Its smart router software finds the best price, sends the order to the exchange carrying the quote and takes responsibility for playing by the rules. The software tells the exchange to do the trade and not bother looking for a better price. This gave Morgan Stanley a speed advantage over its competitors, forcing them to buy their own smart routers to keep up.
In Canada, no one is sure how this will all work. Canadian trading rules require brokers to get the best price for their client. To meet that obligation, brokers must check every visible market in Canada for prices and send orders to the market showing the best one. It sounds simple, but asking questions reveals how many different parts of the market the new reality will affect.
The first issue is these smart routers. "I think smart routers will be essential for every broker on the street," says Michael Prior of Regulation Services. If a trader's algorithms are not scouring information from all the visible markets in Canada, the trader is at risk of breaking the best execution and best price rule. The prospect of buying a smart router and connecting to every different exchange upsets some dealers, because the cost could push smaller brokers out of the business.
The second issue is direct market access, or DMA. DMA is a way for institutions to send orders directly to an exchange by paying a "rental" fee to a broker. Institutions trading this way must follow the same best execution rules as a dealer -- they must find the best price available when they make a trade.
If an institution is using DMA for one exchange, but not another, it will risk breaking these rules. Institutions using DMA, like brokers, will have to check every exchange for a better price before making trades.
Mr. Prior says this will result in a race to the top in DMA standards. Because clients using DMA will have to connect to every exchange, the exchange with the most stringent requirements for DMA access will set the de facto standard for all exchanges. Wendy Rudd, the chief executive officer of Match Now, would prefer regulators impose a uniform DMA criteria right out the gate. According to Regulation Services' Jim Twiss, however, regulators left the issue alone because the markets wanted to do it themselves.
Instead of imposing a DMA standard directly, regulators want to scrutinize DMA clients more closely. They are proposing to force a training course on anyone using DMA, similar to the course forced on traders. They also want DMA clients to sign agreements with either the exchanges or with Regulation Services to prevent DMA institutional from renting their market access out.
Another issue is the TSX's market-on-close option. Market on close is a blind book of orders to be filled as the market closes, set up to protect the closing price from last-minute manipulations. Richard Nesbitt, the chief executive officer of TSX Group Inc., says the TSX owns market on close. Right now, orders from other markets will not be part of the system.
One last issue is when a dealer has to send an order to a dark pool. Because dark pools do not publish order information, which makes it impossible to know whether a better price is available before sending an order, the best price rule does not apply. A dealer has to send an order to a dark pool when there is not enough volume on the visible market to fill the order and if there is a good chance of filling the order in the dark pool. Leakage is one concern. "If there's a dark pool in Canada that I'm not happy with, can I avoid it?" asks one trader. He worries that pretrade information could leak out of some pools, affecting the price. Mr. Twiss does not have a good answer to the question. "Our requirements are evolutionary; we will respond as new markets emerge," he says. |
