Skip to main content

A Toronto Stock Exchange (TSX) logo is seen in Toronto November 9, 2007.Mark Blinch/Reuters

The rapid pace of evolution in stock trading isn't letting up. Having already adjusted to algorithmic and high-frequency orders, Canadians are now bracing themselves for the rise of inverted markets and brokers are left to mull whether they should be in or out.

Historically, the trading world made money through spreads; traders would line up buyers and sellers and then take a five-cent or fee per share. The seller may have received $20 a share while the buyer would pay $20.05 – what was in the middle went to the investment bank.

As high-frequency trading and electronic trading grew, stock exchanges started experimenting with a new model that paid high-frequency traders (HFTs) to post orders on their marketplaces. Known as the "maker-taker" pricing model, traders who removed liquidity, or executed an order and removed it from the marketplace, had to pay a "taker" fee; traders who posted that order got a "maker" rebate.

That's still the dominant model for Toronto Stock Exchange-listed stocks, but there is incredible growth of a new system, known as an inverted market. It works in the exact opposite fashion. People who execute orders and remove them from the marketplace are given a rebate, while people who post orders have to pay to do so.

The rationale: sometimes there is a plethora of orders sitting around, with 20 different investors looking to unload the same stock at the same price. Of that 20, there may be one who needs to get the sale done immediately, so he or she will be willing to pay a small fee to jump to the front of the line. That's why inverted markets are also known as "first look" markets.

The number of investors using these orders is growing fast. In January, 2015, inverted markets made up 9 per cent of trading volumes for TSX-listed securities. Now they make up 15 per cent of all trades, according to ITG Canada.

As their popularity has grown, some market players have raised red flags. Aequitas Innovations Ltd., for one, is concerned. The exchange operator launched last year with a mission to make markets more fair for investors, and its backers have argued inverted markets favour HFTs at the expense of retail investors.

The thinking behind this: HFTs are specialized traders, so they are willing to pay a small fee to be able to interact with retail orders – that is, trades from mom-and-pop investors, who by nature are much less sophisticated. The argument, then, is that the HFTs pay to prey on the unsuspecting investors – though that is hotly debated.

ITG argues another aspect of inverted markets must be considered. In Canada traders have traditionally been happy to show that they are ready to transact, or have transacted, because it signals to investors that they're the biggest players out there. To do this, they post their orders with broker numbers attached to identify which firm they are from. (Most other countries don't do this.)

The downside to tagging where the trade comes from is that it adds an extra bit of information that sophisticated traders can use to their advantage. This is especially true for inverted markets. If someone is paying to unload a stock, it might mean they really have to do the trade.

"The increased use of inverted markets is making larger orders more readily identifiable, and will likely lead to a growing use of Broker 1 in Canada," ITG Canada wrote in a report. Broker 1 is an anonymous label that disguises which dealer executed the trade. At the moment roughly 25 per cent of trades are executed anonymously.

This has implications for investors. "Buy-side clients need to understand how their dealers route different types of flow to fully appreciate how identifiable their own orders are," ITG argued.

It also creates a tradeoff for the dealers. Historically, traders have loved signalling that they're in the midst of all the big orders, because it meant they had the information advantage and could attract more business. By going anonymous, they lose that marketing value.

Yet if they don't do it anonymously, the information could be used against them.

"As inverted market share grows, and institutional desks feel compelled to post more flow on such venues, they will be faced with the unenviable task of determining which is the lesser of two evils," ITG wrote.