Who's behind the TSE's revolution?
ANALYSIS
Large money managers have forced the country's premier
exchange to meet their needs -- or face extinction
Monday, November 9, 1998
RICHARD BLACKWELL
The Globe and Mail
Toronto -- In the insider's argot of the big-volume stock trader, when you want to move a big block of stock quickly, efficiently and quietly, you go "upstairs."
That's where you'll find the trader's version of a "chop shop," where an investment dealer will break the block into manageable chunks and then match them up directly with other clients. It's all done behind the dealer's closed doors, away from the Toronto Stock Exchange's order book, and no one needs to know until it's all finished.
It's all part of a troubling trend for the TSE, which has been losing listings and trades to U.S. exchanges and to the in-house trading of its own members, and faces the imminent threat of private electronic trading systems. Add to that an image badly tarnished by its handling of technological change, staff departures and the embarrassment of listing Bre-X Minerals Ltd. and YBM Magnex International Inc. on its premier index, and the TSE is in need of a makeover.
The exchange has been harshly criticized for dragging its feet in responding to its serious problems. But of late it has plunged into the mess with a zeal little short of revolutionary.
Within the past few months it has beefed up its listing requirements -- starting in August with rules governing mining companies, and more recently making it tougher for firms in other sectors to list on the exchange. In September, it revealed plans to revamp -- and possibly replace -- its faltering indexes and beef up its computer trading systems, and in October it endorsed a blueprint to dramatically restructure the ownership that has governed the exchange for 146 years.
TSE president Rowland Fleming cannot be accused of trying to minimize the severity of the exchange's situation. The 55-year-old former insurance and bank executive, who has headed the exchange for almost four years, concedes that Canada's money management institutions rule the roost. Indeed, he goes so far as to say that the combination of institutional clout and new technologies that see investors trading on private networks is "potentially lethal to us."
For the exchange to ensure that does not happen, it means doing everything possible to keep customers -- particularly institutions -- happy.
"The TSE has to realize that the institutional buyer is going to go where execution is fastest, cleanest and most transparent," said Tom Gunn, chief investment officer of the huge and powerful Ontario Municipal Employees Retirement Board.
"If the TSE elects to operate in a world market but not at a world scale, it will cease to exist as a primary supplier."
The exchange's members -- the brokerages -- also recognize the urgent need for reform.
"Our concern is that the TSE in particular, and the stock exchanges in Canada in general, continue to be as effective as they can to ensure that we have a visible market for Canadian securities," said Aubrey Baillie, deputy chairman of Nesbitt Burns Inc. "I think from what I've seen of the TSE's plans to date, they're heading in that direction."
The big traders
The institutions -- pension funds, mutual funds and other large money managers -- are unapologetic about calling the shots. They control more than 80 per cent of the country's equity holdings, and on any given day a single institution can account for 5 per cent of the trading on the TSE. It's no surprise that they don't have a lot of patience if they can't execute their trades efficiently and cheaply.
"The customers are changing faster than the supplier," Mr. Gunn said. "In that case you just change your supplier if your supplier is not up to date."
The crucial issue for institutions is liquidity -- is there enough activity on the exchange that they can buy or sell big blocks of shares quickly and without having a huge impact on price.
Ironically, institutions have helped contribute to the liquidity problems on the TSE by finding ways outside the exchange to trade shares more effectively. For instance, the shift to trading upstairs in investment dealers' offices instead of on the electronic floor of the stock exchange has partly been prompted by institutions' desires for anonymous buying and selling.
In upstairs trading, a dealer matches orders from among its clients, or with its own positions in a stock, instead of subjecting the block to an auction on the TSE.
Some exchange members blame the big dealers for the trend, rather than the institutions.
"The basic auction market, which is the price disclosure mechanism, is seriously flawed [because of] the greed and irresponsibility of the larger members trying to keep their orders off the floor," said Tom Caldwell, president of Caldwell Securities Ltd. and a persistent critic of the TSE and his bank-owned competitors.
Still, institutional investors concede that upstairs trading has great appeal because it can keep price fluctuations to a minimum. Moving a million-share block of stock in the open market can shift the price of that stock as much as 4 per cent, the investment manager of one large pension fund claims. "If traders see you coming with a big block of shares to sell, the price immediately goes down."
But as more trades move off the floor, liquidity decreases even further, putting pressure on institutions to find more liquid markets.
Increasingly, that takes them to U.S. exchanges where many blue -chip companies such as Bank of Montreal, Royal Bank of Canada, and Northern Telecom Ltd., and about 220 other TSE companies are interlisted. In the eyes of the institutions, the trades are often executed more smoothly and cheaply, and U.S. disclosure laws give them more information on the stocks they are buying and selling.
Private trading
A further threat to the TSE comes from private trading systems that match buy and sell orders by computer out of sight, and control, of the exchange. These systems have been running for about five years in the United States, and now more than 50 companies offer very deep discount commissions, anonymous trading for institutions, longer trading hours and links to more than one stock exchange.
Canadian rules prevent private electronic traders from automatically matching buy and sell orders away from an exchange, but that will likely change soon. Later this year, Canadian securities regulators will issue proposals for how to manage and keep track of these systems on this side of the border.
Companies like Versus Technologies Inc., which runs the Internet discount brokerage E-Trade, are champing at the bit to offer more complete electronic trading services to customers, including institutional investors. "Electronic trading is the future," Versus chief executive officer Doug Steiner said.
The TSE's battle plan to handle these new challenges includes the creation of an "electronic call market" where orders are clumped together into batches and executed electronically at a preset time. This kind of anonymous trading is appealing to institutions because it means traders won't be able to see them coming with big blocks to buy or sell.
"The case for a call market is very convincing," Mr. Fleming said, but when pressed for a timetable he said only that he's "optimistic we'll see progress in the near future."
The TSE is open to much more dramatic changes, he added. It will even consider letting investors trade directly on the exchange without using an investment dealer as an intermediary.
"I can see the day when we would allow retail investors with a PC in their home to have access to the market however it is defined in cyberspace."
There's no overriding regulatory or technological reason, he said, why a retail investor sitting at a home computer, or an institutional manager in an office, shouldn't be able to connect directly with the TSE's trading engine.
That engine, the subject of much controversy after the TSE dumped more than $25-million down the drain trying to upgrade its computers in the early 1990s, will be completely upgraded by the end of next year, Mr. Fleming said.
On top of the technological upgrades, the TSE plans to boost the derivative market through its new and improved indexes. A 60- to 70-stock index, created with the help of Standard & Poor's Corp., is expected to be in place by the end of the year. The exchange also says it will strengthen the role of individuals who act as market makers, and make sure it keeps its role as the gatherer of all posttrade information, no matter where the trades take place.
While the TSE has won praise for its blueprint, even its supporters wish there was a little more flesh on the bones.
"It's still vague," said Ian Russell, senior vice-president of capital markets at the Investment Dealers Association. "I would have liked to have seen more detail."
That detail will come, Mr. Fleming promises, as the TSE's governors and staff fan out to try to convince the current members to accept what is perhaps the most dramatic change to the TSE's operation -- a revamp of its ownership structure.
To ensure big decisions on major issues can be made more quickly in the future, the TSE's board of governors proposed a new regime that could see the exchange become a for-profit public company.
Initially, the 102 investment dealers in the TSE co-operative would get shares. Institutional shareholders and listed companies would later get a crack at ownership, and further down the road the shares might be open to public ownership as the exchange becomes a listed company.
While some industry players have questioned the need to change the TSE's ownership in order to implement other changes, Mr. Fleming insists the two are linked.
"Look how long it took us to close the trading floor with consensus management; look how long it took to implement decimal trading," he said.
In addition to making the exchange more entrepreneurial, Mr. Fleming said, the TSE would also have a much broader range of ways to raise money when it needs to, particularly for technological spending. Right now, he says, "the members of the TSE are quite parsimonious when it comes to making investments."
Most members of the TSE appear to support the new ownership concept, which will remove their unlimited liability and give them a potential gain on the value of the shares they'll get in the "new" TSE. Currently, each seat is worth about $50,000.
However, there are some misgivings.
"I suspect there will be a few dealers who will question whether the change in structure is necessary to implement the change in strategy," said Mike Tims, president of Peters & Co., a Calgary-based brokerage. Still, Mr. Tims said, his firm will probably support the TSE when it comes to vote on the change.
Amid all this change, the issue of regulation continues to be among the thorniest of issues. Should the TSE continue to regulate the market, even after it goes public.
The TSE says yes. Its blueprint for change says it already has a "world class reputation" for a fair, efficient and well-regulated market. Regulating market quality "is an essential element of the exchange's overall reputation," it says.
That's crazy, according to Mr. Steiner of Versus Brokerage, a company that would like to steal some of the TSE's electronic trading business. A for-profit, more electronic TSE would be a direct competitor for Versus and others that want to get into this business, and therefore "it is inappropriate that a company that competes in a market should want to regulate it too," he said.
Regulatory authority should be shifted to the Ontario Securities Commission, Mr. Steiner said. "In order to foster competition you need an independent [body] regulating the market."
ABOUT THE TSE
1852: The Association of Brokers is formed by 12 Toronto businessmen who begin to trade securities.
1878: The Toronto Stock Exchange is incorporated. It had 14 members and traded fewer than a dozen stocks.
1998: 102 member investment firms governed by a 15-member board of governors.
Number of companies listed 1997: 1,720
Number of companies listed as of Sept. 30, 1998: 1,446 (1,745 issues)
Market capitalization, 1970: $153,994,046
Market capitalization, 1980: $447,025,741
Market capitalization, 1990: $703,372,692
Market capitalization, 1997: $1,270,348,318
Money spent to fix the Year 2000 computer problem: $27-million
Trading and related fees, 1997: $48-million
Listed company fees, 1997: $40.2-million
Number of interlisted stocks with U.S. exchanges: more than 220
Number of Canadian companies that list directly on Nasdaq: 66
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