A growing chorus of Bay Street traders and money managers is sounding the alarm over a recent jump in how often a single brokerage executes both the "buy" and "sell" sides of a stock trade.
Late last year, after months of fielding complaints, a coalition of Canadian investment watchdogs said it would investigate concerns that certain types of trades are being unfairly "internalized" by some of the country's biggest investment houses – potentially at the expense of other trading shops and their clients, which include pension and mutual funds.
On Wednesday, TMX Group Ltd. is hosting a closed-door Toronto event for brokers, asset managers, equity market operators and regulators to discuss the issue. Representatives from the capital-markets arms of five of the six big banks will be there, as will members of four provincial securities commissions, the Investment Industry Regulatory Organization of Canada and the Ontario Ministry of Finance.
At its heart, a stock exchange is a place where buyers and sellers can come together to get the best price on a stock. But the rising incidences of so-called internalization of order flow – when dealers take the other side of a client trade – brings into question whether brokers should be allowed to employ advanced technology to boost the odds that their smaller client orders won't be accessible to the broader market.
While no claims have been made that any regulations or laws are being broken, the worry, critics say, is that same-broker trading could result in pools of activity forming in silos, away from the main stock market. This, in theory, could diminish the process for setting prices and degrade the vibrancy of the overall Canadian market.
For regulators, these concerns raise some tough questions: What's driving this rise in same-broker trades? Is anyone being harmed? Are new rules necessary?
John Christofilos, chief trading officer at AGF Investments Inc., says the sudden rise in the number of trades with the same broker on both sides is unusual and alarming.
"How they are doing it, I don't know," he said. "But longer term, I'm concerned that less is getting to the floor, which means that it's more difficult to get trades done. It's very frustrating. Something needs to get explained."
According to public market data, there has been an increase in the rate of smaller same-broker trades at Canada's two largest retail brokers – Toronto-Dominion Bank and Royal Bank of Canada. TD and RBC officials say they are doing good by their clients, offering them best execution and keeping the banks' costs down.
This spike in same-firm trades is, in theory, a reflection of an increase in accidental collisions between small orders. Such trades are known as unintentional crosses.
Unlike large block trades – where an asset manager phones a broker and asks them to find the other side of the trade – unintentional crosses occur in part because of an old feature built into the matching engines of some Canadian stock markets that prioritizes orders from the same brokerage.
Let's say there are three orders from three different brokers waiting to buy a stock for $10. The orders are ranked first by price, then by time priority, meaning the first order will get filled first. However, if an order to sell that stock for $10 comes in from the same brokerage as the order sitting third in line at the best price, that order will jump the queue.
Thanks to this feature dating to the 1990s, known as broker preferencing, the two older buy orders must keep waiting to be filled – even though they took the risk of showing their hand to the market.
"I don't want to expose myself if others aren't exposing themselves in terms of depth," said Mr. Christofilos. "That becomes a compounding issue. If there's less to pick from, it means the market is going to move against us."
In the mid-2000s, the buy side and most brokers were too slow to keep up with the ultra-fast traders entering the Canadian market. Back then, these players could have spent more on technology to speed up and compete. When it comes to the problems posed by same-broker trades, spending more won't help much. Today, liquidity is becoming harder to access – even for the fastest players in the market.
"Here, the general sense is we don't even get access to that [order]," added Mr. Christofilos. "You can buy a Ferrari, it doesn't matter. You don't have a chance at it."
That perception can quickly diminish the vitality and integrity of the broader stock market.
"The institutions want to be able to compete on the quote," said Doug Clark, who researches equity market structure at broker ITG Canada Corp. "If you disincent me from providing a quote because I'm not participating with the flow, I'm going to be less aggressive and you'll get wider spreads. Everybody gets harmed in the process."
TD says the spike in its same-firm trading is a result of its clients colliding with other clients more frequently, driven by "an unprecedented" increase in retail trading volumes.
"The increase in unintentional crosses over the past few years has all been retail-retail," said David Panko, the global head of equity derivatives at TD Securities Inc.
He added that TD works to provide best execution by matching "clients with each other rather than trading one client order with an intermediary and leaving the other client unfilled. Bringing clients together is a key role of a full-service dealer, and contributes to the low cost and efficiency of trading in the Canadian equity market," he added.
Mr. Panko is set to present on behalf of TD at Wednesday's industry event. RBC officials, however, won't be attending because they "don't believe TMX is the appropriate party to convene this discussion," said Greg Mills, head of global equities at RBC Dominion Securities Inc.
RBC has an equally protectionist view of its order flow. "Each time RBC doesn't trade with RBC, we're trading likely with intermediaries or HFT [high-frequency trading]," said Shary Mudassir, a managing director in global equities trading at RBC.
Last summer, RBC debuted a new market-making system that uses technology to co-ordinate how retail, institutional and the bank's own order flow is being sent to the market. Since then, the bank says its unintentional cross rate doubled to 10 per cent, as of the end of last year.
"What we have done is figured out a way to route our flow smarter than we have in the past," said Mr. Mills. "That's not internalization. That's optimization."
RBC is sending a large portion of the orders being handled by this system to Aequitas Neo Exchange Inc., a young market of which RBC owns a stake and Mr. Mills is the chair. Last summer, Aequitas capped the monthly fee it charges for unintentional crosses at $10,000, allowing RBC and others who employ a similar strategy to save money.
Mr. Mills says he met with officials at the Ontario Securities Commission as early as last July to discuss the system RBC was deploying. One of the questions he was asked was why other brokers weren't doing the same, Mr. Mills recalls. "And we said, 'They should be.'"