To understand why trading volumes are exploding in blue chip Canadian stocks, take a moment to consider the concept of locking a market.
We'll get to what's playing out behind the scenes at Bombardier, OPTI Canada and Uranium One in a moment, but let's start with an metaphor from the world of auto dealers.
Suppose Eastside Ford was offering a $1000-rebate to anyone willing to buy a new minivan. On the other side of town, Westside Used Cars decided to pay the full market price for nearly-new Ford minivans, to fill its lot. In this scenario, some enterprising soul would lock in a $1,000 profit by buying from Eastside, and promptly selling to Westside.
Got the picture? Okay, now substitute a high-volume stock such as OPTI for the minivan. And substitute any one of a number of stock exchanges for the car dealership. The Toronto Stock Exchange and upstart rivals such as Alpha, Pure and Chi-X Canada offer rebates in certain situations to those who provide trading liquidity.
Those rebates, and the advantages that come with having the fastest trading systems on the Street, have led to an explosive increase in what's known as High Frequency Traders (HFT), which are also known as Electronic Liquidity Providers. From a standing start just over a year ago, when new exchanges launched to compete with the TSX, the HFT crowd now accounts for as much as 15 per cent of Canadian stock trading. While that's impressive, this type of trading is now estimated to account for more than 50 per cent of the volume of U.S. equity trading.
The new players in Canada include companies such as Tradebot Systems, and one of their favourite strategies is a lock markets. Dealers such as CIBC have seen their trading volumes soar, in part by catering to this crowd with extremely low trading prices and quick, easy market access.
Here's what an HFT might do with OPTI. They would use sophisticated, computer-driven trading to buy the stock for $3.45 on one exchange while selling it for $3.45 on another. The profit on this risk-free cross would be the rebate from an exchange, which would then advertise an apparent spike in traffic. Some of the HFT systems are so quick that they can jump the queue in exchanges, snapping up buy or sell orders that are being processed by slower systems.
What have a few high frequency traders done to traffic flows on Canadian exchanges? Buying and selling of OPTI now averages 4 million shares each day, up six-fold this year. Bombardier volumes are up over 300 per cent in the past 18 months. Uranium One trading has doubled since last summer.
All this new volume is deceptive. Few new, traditional shareholders have bought into a company. Instead, the HFTs simply generated a whole lot of trades in small lots of stock - at most, a few thousand shares are bought and sold at a time. The HFT trades are designed to blend in with other more traditional trading, so as to avoid detection.
Of course, those who aren't in on the game can be fooled - witness the speculation recently on a possible bid for OPTI, driven in part by the spike in volume.
As one equity desk veteran pointed out in discussing what he called "phantom liquidity" at OPTI, a show of interest from the HFTs got the attention of momentum traders, who mistook it for increased investor interest. These momentum traders jumped into the stock, and the new volume created additional arbitrage opportunities, which enticed more HFT interest.
To date, Canadian regulators have opted to ignore locked markets, although U.S. market watchdogs have taken steps to curb the practice. The Canadian Securities Administrators did ask for comments on a proposal to prohibit the practice last year. A number of dealers stepped up to say locked markets are an increasingly large problem, and should be banned. But the CSA and our patchwork of provincial and national regulators have not followed through.
For now, the onus is on investors to stay informed. If the volume of trading in a widely-held stock is soaring, with no apparent reason, the company may be in play. But the more likely explanation is a handful of computer-based programs are hard at work locking markets, and earning rebates on risk-free trades.