07.07.2017
By John D'Antona

FLASHBACK FRIDAY: Catching Up

Stock trading in the Great North had always been the purview of a select number of big banks and done via telephony using human sales traders. Electronic tools and dark pools were barely used as Canadian regulations drove trades into the public markets just a few years ago.

But now things are different. It’s 2017 and electronic trading, dark pools and commission spend have all played an integral part of Canada’s unique market structure. But have the changes over the past six years made the market better? Cheaper?

Doug Clark, Managing Director, Head of Research, ITG Canada recalled that Canada has historically been a global leader in innovating secondary equity trading. It was among the first to introduce electronic trading back in 1977, ETFs in 1993, decimalization in 1995 and the trade-at concept in 2012, he said.

“Canada has never been shy about wandering down untraveled paths,” he recently told Traders Magazine.

He continued to tick off the changes in the Great North – new markets such as chi-X, Pure, MatchNow, Alpha and Omega introduced a new wave of change and innovation. Alpha had introduced the first participant segmenting mechanism, with its IntraSpread dark pool, which limited the active side to just retail investors (a mechanism NYSE would later replicate with their RLP program).

“While IntraSpread would become a victim of the 2012 dark rules, the barn door was opened wide and the wave towards segmentation would dominate marketplace ‘innovation’ to present day,” he said. “The Alpha speed bump discouraged large institutional liquidity seekers, while delivering pure retail flow to market makers.”

Other venues introduced mechanisms mimicking true real market making facilities to help larger firms better internalize retail flows, to the frustration of some liquidity starved institutional investors.

Clark said that the Canadian market of 2017 is arguably the most complex of any secondary equity market in the world, but unlike the days of yore, much of today’s innovation and complexity is aimed at aiding intermediaries.

“In this regard at least, the lesson for other jurisdictions is not to emulate the complexity of Canada, but rather to steer in the other direction,” Clark said.

 

The following article originally appeared in the July 2011 edition of Traders Magazine

 

Catching Up

Canada Follows U.S. Into Electronic Trading Era

Much of the talk these days in Canada’s financial industry centers on the battle being waged for the Toronto Stock Exchange, between the London Stock Exchange and the Maple Group bank consortium. One offer, it is said, would remake the stock trading industry into a global hot spot. The other would turn the clock back, relegating Canada to yesteryear.

But behind the headlines, an arguably more consequential meat-and-potatoes drama is taking place, as Canada’s stock market rushes helter-skelter into the electronic era.

In one of the latest developments, TMX Group, parent of the Toronto, is set to launch an ECN-type platform this month, in a bid to recoup market share lost to a host of electronic upstarts.

Once the only venue in Canada where traders could buy and sell stock, the exchange now finds itself being crowded out by newer, cheaper and more technologically advanced competitors.

TMX Group’s new venue, TMX Select, will cater to high-frequency traders and retail day traders. The alternative trading system will seek to distinguish itself with its pricing and a few other attributes.

The Toronto’s foray into the ATS business is indicative of this once high-touch, bank-run market’s broader movement into the 21st century-replete with algorithms, new exchanges and dark pools-and a market structure more fully embraced in the U.S.

Heretofore in Canada, orders were phoned into dealers who did or didn’t commit capital but then sent orders to the Toronto via direct market access.

Now, with the explosion of multiple trading venues, both the brokers and the buyside are increasingly using algos to get their orders filled, as well as DMA.

Changing Times

The increase in electronic trading is being driven by a confluence of factors. First and foremost, the buyside’s demands for increased liquidity, lower commission rates, more control of its order flow and greater transparency are pushing the old trading ways aside. International traders looking for exposure to domestic companies want a degree of homogeneity between how the True North trades and the rest of the globe. Lastly, the regulators looking to create a more transparent marketplace are embracing the move.

Renee Colyer, Forefactor

Whatever the case, the Canadian equities markets and market structure are increasingly looking like those of the country’s southerly neighbor.

“The impression is that we seem to be behind [the U.S. and other countries] and are playing rapid-fire catch-up when it comes to electronic trading,” said Renee Colyer, chief executive at Forefactor, a Canadian research firm. “The regulators are trying to keep up with everything that is changing, and it seems like no one really can, not even the banks. A lot of people don’t like change, and for some, it’s hard to deal with.”

Change can be hard even for firms like Investment Technology Group, one of the earliest brokers to offer electronic trading in Canada. At a recent industry conference, ITG chief executive Robert Gasser talked about the developing Canadian market structure.

“Canada is fragmenting,” Gasser said at a Sandler O’Neill exchange and brokerage conference. “It’s very chaotic up in Canada.”

Chaotic or not, Heather Killian, executive director at CIBC World Markets, told Traders Magazine her firm welcomes marketplace development and competition, and believes they positively contribute to making the firm better at what it does.

“Our approach is destination-agnostic, and we will go where our clients want us to go,” she said.

Killian said CIBC has been actively embracing electronic trading and its challenges, such as by developing its own low-latency smart order-routing technology, which includes risk filtering capabilities. CIBC is also providing clients DMA and algorithms.

“[The algos] were developed internally to take into consideration the unique nature of Canadian trading relative to the U.S.,” she said. “We evolved our operating model and client base to meet the challenges of the new market structure.”

Paper Tickets

Up until January 2008, if anyone wanted to trade Canadian stocks, the only place to do so was on the Toronto-it had 100 percent market share. Fast-forward to May 2011, and the picture is dramatically different: Now there are five and soon to be seven lit markets vying for traders’ business. And several trading professionals estimate that the Toronto Stock Exchange’s market share has dropped to 59 percent.

On the attack are Alpha, an ECN owned by a consortium of big Canadian banks, which now has 22.0 percent of the market; Chi-X, a unit of Instinet with 10.0 percent; and Pure Trading, with 4.0 percent. Pure is partly owned by several venture capitalists, Dundee Bancorp and UBS. Omega (owned by Marlar Group, a New York-based technology firm), Orbixa (formerly day-trading firm Swift Trade) and Tactico (a venture management and business advisory firm run by former Penson execs) captures 1.5 percent.

While the increase in trading venues was good for the buyside, it wasn’t for the sellside, Colyer said. Brokers now have to incur higher fixed costs as they are forced to plug into these new entrants or risk losing business.

Although the Toronto actually went fully electronic in 1997, around the same time ECNs were making inroads into the U.S.’s Nasdaq market, it has only been in the past few years that the Canadian industry has felt the full brunt of electronic trading. It wasn’t until 2008 that the number of electronic marketplaces there exploded.

Prior to 1997, some floor trading and virtually all upstairs trading on the Toronto was high-touch-using paper tickets, phones, floor brokers and stamping machines.

By comparison, electronic trading in the U.S. took root in the late 1990s, when the Securities and Exchange Commission approved Reg ATS and allowed ECNs to come into existence. Electronic matching systems mushroomed in the Nasdaq market, allowing DMA-wielding day traders to participate in the technology boom.

So the first electronic communications network surfaced in the U.S. in 1998, while the first comparable network in Canada didn’t show up until 2007.

It comes as no surprise to those in the Canadian industry that the Land of the Maple Leaf has been a bit slower to adopt electronic trading. Pros said the country’s conservative mind-set and less-liquid stocks just didn’t lend themselves to the benefits of automated trading.

There is little available data on the amount of electronic trading in Canada. All orders are sent to electronic books, as off-board printing is not permitted, but much of that is still done via direct market access. While DMA is technically electronic trading, many consider this older point-and-click style of trading to be “manual” trading.

Greenwich Associates reported that in 2010, the buyside sent 16 percent of its orders to exchanges and dark pools via algorithms and direct-market-access tools. It sent the remainder to their sales traders either as single-stock or program trades. What the sellside did with those orders is a mystery. Best guess is that the sellside splits its orders evenly between DMA and algorithms.

According to data from Forefactor, which tracks both buyside and sellside usage, algorithmic trading and DMA in 2008 constituted about 30 percent of all Canadian trading volume. While updated figures are due to be released shortly, the firm estimates that algorithmic trading will grow to roughly 45 percent of trading volume, excluding HFT trading.

Study participants told Greenwich they expect the total will rise relatively modestly, to just 18 percent over the next three years.

In the U.S., the vast majority of institutional orders are handled by algorithms overseen by brokers or the buyside themselves. Very little point-and-click DMA-style trading remains.

Due to the advent of ECNs and algorithms, the industry in Canada is witnessing changes in the economics of trading similar to those already seen in the U.S.

Trade sizes dropped as a result of more alternative trading venues sprouting. According to traders, prior to 2003, the average trade size in Canada was around 1,500 shares. As a result of automated slicing and routing of orders, that size has now shrunk to 600 shares.

Along with the decline in trading size, commissions have fallen. Five or six years ago, the average commission rate in Canada was 3 cents Canadian. Today that figure is 2.5 cents, Greenwich said.

According to Greenwich’s latest report, covering 2010, total commissions for that year came in at C$695 million. This compares to C$690 million in the 2009 report, with a blended commission rate of 2.46 cents. But in the 2008 report, commissions totaled C$845 million with a blended commission rate of 2.66 cents. According to anecdotal reports from traders, commissions were higher prior to the recorded Greenwich data.

Besides falling commissions, Colyer said, the banks and broker-dealers still have other worries as electronic trading gathers steam. She said those who have electronic offerings should be able to keep pace with technology, but smaller brokers or others who do not have deep pockets or in-house technology expertise will likely have to look for a third-party solution.

“You’ve got some bank-owned broker-dealers who will scramble to get on board while a few are already playing in the electronic space,” Colyer said.

She pointed to CIBC, who told Traders Magazine they have an electronic trading desk. RBC Capital Markets already offers clients its THOR smart order-routing technology, designed to prevent HFTs from gaming the buyside. Colyer also said Toronto Dominion Bank has been white-labeling algorithms from Goldman Sachs and offering them to clients for the last few years.

“The Canadian banks and their trading desks were taking in less business than the U.S. firms because the U.S. broker-dealers were the first to market,” Colyer said. “More established firms such as ITG and Credit Suisse have consistently been doing well in Canada’s electronic trading markets. In previous research, we noted that the U.S. dealers were eating the Canadian banks for lunch.”

Made in the USA

And the reality is that the algos being used in Canada are coming for the most part from the U.S. To date, Forefactor’s electronic trading and technology studies have revealed that U.S. companies are being viewed by Canadian institutional investors as leading the pack as algorithm vendors. No Canadian bank-owned broker-dealers are in the top tier.

On the algorithm front, the first deployment of algos by U.S. brokers came in 2001, when Credit Suisse started offering them to customers as a way to deal with decimalization. The frenzy over algos in the U.S. really took root in the 2003-2005 period, when all the major brokers began building and deploying the trading tools.

Algos first made an appearance in Canada in 2003. The Americans were the leaders here too, as Credit Suisse, ITG and Morgan Stanley provided the Canadians with their first algos. However, algorithms didn’t take hold, because the buyside was still accustomed to phoning its orders to the sellside, which tempered demand. Early algos seen in Canada were volume-average-weighted price types, not the more sophisticated ones, like implementation shortfall, being used in the U.S.

Now, though, the frenzy of algo development is really hitting its stride in Canada, with more vendors developing algos for both the buyside and sellside.

The Forefactor report results noted that algorithmically executed trades account for 36 percent of total trades originating in Canada and executed by reporting brokers participating in the study.

Furthermore, institutional investors in the report said ITG currently leads the pack in executing trades algorithmically, followed by Credit Suisse and Morgan Stanley.

Michael Thom, Genus Capital

Six years ago, Instinet’s Alison Crosthwait said, there were only a handful of algorithms available to buyside traders. Not so any more, she said, as third-party vendors, sellside bulge bracket firms and to a lesser extent some Canadian banks now offer algorithms. Even smaller Canadian broker-dealers are aligning themselves with larger firms to gain access to algos and offer them to clients and bring in business.

“You can’t have an execution offering without some kind of algorithm partnership,” Crosthwait said. “The buyside wants to send some of their order flow through algos, as they reduce trading costs, and they want a low-cost, efficient way to pay for their research bills.” [

The buyside is already moving forward into the electronic age, embracing algorithms, dark pools, smart order routers and other advances. Buysiders also told Traders Magazine they are increasingly entering their orders directly into algorithms or sending them via FIX protocol to the sellside, which then places the order into an algorithm.

Kelly Reynolds, director of trading at Toronto-based Hillsdale Investment Management, told Traders Magazine that her firm is already active in one Canadian dark pool, ITG TriAct’s Match Now, and she is also in the process of getting connected to Liquidnet, and has been closely monitoring activity in Instinet’s Canada Cross since its launch on May 25. She also places her orders directly into algorithms for execution, bypassing her brokers at times.

“Yes, I’m using algos from various providers,” Reynolds said. She added that her future algo usage depends on whether new algos appear in the market that are innovative and that can improve or support her trading strategies. While client-specific algo customization is readily available, it is impossible to predetermine strategies for every possible circumstance, as the market is in constant flux.

She is not alone. Michael Thom, a buyside trader at Genus Capital Management, said he too enters his orders into his algorithms himself, rather than rely on the sellside or the banks. And if algos help him source liquidity-even “marginal liquidity”-then their use is justified, and preferable to manually handling an order.

“It’s our job to find liquidity wherever it hides,” Thom said. And if that means using algos, that’s fine with him.

However, algos do have their limitations. Reynolds pointed out that many assume algos are used to be stealthy and can reduce market impact. The reality, she said, is that the algos most prevalent in the Canadian market are still plain vanilla, schedule-based algos whose usage creates patterns that can be reverse engineered-even with anti-gaming measures in place.

While upstairs trading has been a hallmark of the Canadian industry, the introduction of dark pools has provided the buyside with another way to execute its orders discreetly.

Here too, U.S. brokers are at the forefront and making inroads into the ATS space. They are capitalizing on their established programs and giving the buyside what it wants: more anonymous liquidity at a lower price.

The buyside’s search for more liquidity has given birth to five dark venues: ITG’s Match Now, Liquidnet, two from Instinet and Goldman Sachs’ Sigma X. Alpha has also said it would have its own IntraSpread dark pool up and running by June 20.

As for dark pools, the spawning frenzy in the U.S. took place between the 2005 and 2007 period. But they had been around since 1986, when agency broker Instinet opened the first, After Hours Cross, and in 1987, when ITG launched Posit. They just didn’t go mainstream until later. Dark pool volume now accounts for about 14 percent of volume in the U.S.

Canada saw its first dark pool in 2006, from Liquidnet, and the second in 2007, from ITG. Instinet entered the True North just last month, as did Goldman Sachs with Sigma X.

“I will trade wherever there is liquidity that does not unduly signal the market of my intentions,” she said. “The key is trading ‘size’ with the least market impact possible.”

Mike Bignell, president of Omega ATS in Canada, said dark pools will most certainly grow as continued use of algorithms drives ATS growth. With trade fill size falling, the buyside’s search for size and better overall fill rates will push them off-board.

“With the growth of HFTs here, it is sometimes a lot safer for the buyside to come into the dark side,” Bignell said. “I’d say dark pool volume could hit 10 percent by end of year, from the 3 percent levels it’s at now.”

In the U.S., the growth in dark pools has come at the expense of the lit markets. Flow once destined for their books never makes it out of the brokerage. In Canada, the Toronto is determined not to be cut out. It is launching TMX Dark, a fully hidden order that trades at the midpoint for a subset of stocks.

The biggest advantage of TMX Dark orders is that they use the same pricing data that is in the visible market, preventing adverse selection and trade-throughs.

“We expect to see continued innovation in dark orders over the next six to 12 months,” Clark said. “TMX and Chi-X will likely come out with more-not so much the other exchanges.”

According to the latest data from the IIROC, dark pools have been slowly growing in terms of percentage of total monthly daily volume. ITG garnered a 1.6 percent share in April, versus 1.1 percent in March; and Liquidnet, which focuses on block trades, had 0.16 percent of the market in April, compared with 0.14 percent in March. There are no data for Instinet and Sigma X, who have just begun operations.

Up to now, Canadian regulators have been cautiously watching U.S. markets and talking about jointly proposing updates to existing rules that would effectively curtail U.S.-style dark pool trading. Behind the thinking is a long history of transparency in a marketplace that requires all trades to be taken to an exchange or otherwise “lit” market to be printed.

Some speculate that Canada’s three regulators could introduce rules that limit dark pools. The Canadian Securities Administrators, the Ontario Securities Commission and the IIROC haven’t proposed anything as of yet.

Despite regulators’ concerns and a potential minimum trade-size requirement, growth in the Canadian dark pool market is expected to continue. As of this writing, other bulge firms, such as Credit Suisse, Morgan Stanley and Bank of America Merrill Lynch, are expected to enter the space.

“We’re going to see a number of new pools come here that are designed to be more innovative and more cost effective than what is already here,” said Doug Clark, managing director at ITG. “If they add more options to clients on where to trade, offering more choice and flexibility, then that is a positive development.”

And with more pools comes more liquidity. Hillsdale’s Reynolds said that a slightly higher percentage of her firm’s orders have recently been getting filled in the dark, thanks to dark pools’ ability to provide anonymity and liquidity.

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