Electronic trading. It TSXinks. It TSXinks
Electronic trading should help small investors get a better deal. But the TSX is helping big investment dealers build systems that could do the opposite
By DOUG STEINER
As an investor placing orders to buy or sell shares "at market," do you feel like turning the clock back 10 years and helping investment dealers make more profits?
This fall, the New York Stock Exchange was boiling after chairman Dick Grasso picked up a cheque for $140 million (U.S.) on his way to the beach. The NYSE's archaic manual trading system has also come under fire. Orders are still routed through the exchange's trading floor, but on the way they pass through some clever intermediaries. Investors large and small argue that they could get better prices by dealing through an unbiased electronic trading system.
We should be hot and bothered too. The Toronto Stock Exchange eliminated its trading floor and went totally electronic in 1997. But it has also cleverly cemented its near-total national monopoly on public stock trading. Now, the TSX is working quietly on new technology that will enhance its monopoly and boost investment dealers' profits. For small investors, that will actually make it harder to see what's going on, or to get better prices on trades.
To understand what's happened, let's review some history. In the mid-1990s, officials at the TSE (as it was known) saw alternative electronic systems such as Instinet emerge in the United States. Afraid of similar competitors here, TSE staff warned about market fragmentation: With too many exchanges and electronic markets, the poor small investor wouldn't know where to get the best price.
In 1995, the TSE struck an industry committee that looked at automated trading. The goal was one efficient, transparent market for everyone. In 1996, the TSE invoked new rules to get small customer orders placed directly in its central order book-the public record of bids to buy and offers to sell. It became a lot harder for dealers to slide in ahead of clients, or to trade the other side of the order on their own account.
In 2001, the Ontario Securities Commission passed rules to encourage alternative trading systems and competition. But Richard Nesbitt, the president of TSE CDNX Market Services, warned of an "Armageddon scenario" if five or six big bank-owned dealers set up their own systems to internalize their own order flow, leaving the TSE-and retail investors-out of the order display loop.
In 2002, the dealers sold part of their stake in the renamed TSX with an IPO. But they retained majority control, as well as $373 million in proceeds from the issue. The high-IQ dealers also realized that the new OSC rules could be used as a whacking hammer to extract concessions from the TSX. Facing the threat of cheap dealer-controlled exchange substitutes, the TSX bent over backward trying to keep them happy. New volume discounts lowered the big dealers' trading costs. The TSX also allowed the dealers to hide the origin of equity orders and trades if they wished.
Big dealers receive thousands of orders a day, and it's often very profitable for them to match buyers with sellers themselves. Dealers like buying from one party and selling the same equity to another later, usually keeping a handsome difference for themselves. In the old days, though, internal order-matching was a highly manual and inefficient process.
The new TSX system will help large dealers internalize order flow. That will make it easier for them to trade "against" clients. Orders won't reach the exchange, where another dealer could offer a better price. Nice. The TSX also quietly arranged to have some trading rules changed, almost back to the way they were before 1996.
So what will happen? The vast majority of TSX orders come through the bank-owned dealers. They will match the bulk of them in their new TSX-built systems. The public market will be less liquid, and the spread between bid and ask prices on securities (the highest price a prospective buyer is willing to pay and the lowest a seller is willing to accept) will widen. Dealers will make more money. The TSX still gets a transaction fee, so it is indifferent. It gets paid for trades, not for getting you a good deal.
You can't blame the TSX for trying to protect its monopoly, but it's hurting its real customers. This move has caught the attention of some savvy technology providers, including the technology investment fund I run, and it would be nice if some real investor-friendly competition arose. In the United States, where real alternatives exist, the average cost of a transaction on Nasdaq has dropped to 0.18 cents (U.S.) per share from 0.9 cents (U.S.) over the past 18 months.
If the TSX wants to be a monopoly, it should be like eBay and earn the right to be a central market where all orders are treated equally. Officials shouldn't make private deals with big Bay Street dealers in an attempt to cement their monopoly's future.
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