They go by a lot of names. Third markets, ECNs, dark pools, but their conventional moniker is Alternative Trading Systems.
These off-exchange venues are finally gaining ground in Canada, after making a big splash in the U.S. a decade ago. And recent entry of some major clearance, settlement, and back office players into the Canadian market means one of the missing pieces to larger scale ATS activity has finally slid into place.
Traders love third-market systems because they provide anonymity; a tool that’s especially important for people who want to move large blocks of stock (or cobble together a large buy order from multiple sellers). Such orders made on large exchanges can move markets drastically, and make it harder for buyers or sellers to complete large orders at a good price.
This anonymity caused the systems to gain massive popularity in the States during the 1990s bull market. Broker-dealers also revered the ability of ATS platforms to offer lightning execution and deeper quote information than what was offered by traditional exchange montages at that time. They further lowered costs for traders, buyers and sellers by offering penny- and sub-penny pricing at a time when stocks on U.S. markets were still trading in eights.
But ATS activity also caused regulatory worries. Multiple markets meant too many quotes, and created problems for utilities charged with aggregating data and reporting prices. Buyers and sellers of stock, too, started questioning whether brokers were working with an ATS because it was simple, or because it was in fact providing the most efficient and best priced execution.
Efforts to determine the place of third market trading systems in stock markets worldwide go back to a late 1999 SEC concept release that looked at the fees paid for aggregation of price data, since those fees were used to fund Self Regulatory Organizations. As an alternative to the existing fragmented system, the SEC staff posed the possibility of creating a Centralized Limit Order Book open to all.
Those initial discussions ultimately set off a major discussion among market players over who actually owned the price quotation information that was being trafficked over non-SRO affiliated trading systems. Next came further SEC concept releases and eventually a new set of order routing and execution rules that required brokers to issue reports indicating where client orders were executed, at what time, and at what price.
The regulators’ stated objective was to protect investors from trade throughs; instances in which orders are executed at inferior prices by brokers who are just looking for an easy execution or are deliberately steering business to a preferred trading partner. These arrangements were common in the soft-dollar rich environment of the late 1990s and early 2000s (you buy my trading terminal, I send you orders).
But the regulators had other, more intellectual, motives. At the time, SEC officials said privately that the true purpose of the discussions about data aggregation was to lead the industry to a definition of best execution – that delicate balancing of price, time, speed and anonymity – and the level of price transparency that brokers needed to achieve it. They never achieved that goal, but they did eventually settle on Reg ATS to govern the use of third market venue and eventually the National Market System Regulation intended to guide all market activity.
As Alternative Trading Systems gain hold in Canada, those same questions are sure to emerge, but hopefully we’ll reach different conclusions. The entry of electronic trading in the U.S. served as a trigger point for a ramping up of regulation writing at both the Federal and SRO level. And the Canadian Securities Administrators has responded to concerns about ATS entry into our marketplace with a discussion paper, and a promise to deliver recommendations on trade-through protection this month.
While regulators will work to ensure broker relationships with ATSs don’t become so cozy that clients receive inferior executions, they’ll also want to see traders making use of the deeper level of bid and ask prices being quoted on ATS platforms to ensure adequate quote depth is being reviewed.
For advisors and brokers, the changes present huge opportunities to provide superior service. More quote data means clients can be given better prices, particularly for large executions. And clients are very price sensitive these days. Advisors who like to go over execution reports will, over time, be able to determine which brokers do the best job of consummating trades. Armed with this knowledge, they’ll be able to paint a reassuring picture of their trading work to clients.
In some ways, it’s funny that ATS utilities are coming on strong in Canada just as they’re once again being put under the microscope down South.
Both the New York Stock Exchange (NYSE) and Nasdaq dislike ATS trading since it siphons orders from major exchanges. Having a current SEC chair who formerly held numerous high-level positions at the National Association of Securities Dealers, and later FINRA, meant the trading venues were bound to come into the Commission’s sights sooner or later.
The ongoing credit crisis, meanwhile, provides the perfect opportunity to turn ATS platforms into scapegoats by painting them as tools of Wall Street trickery. New York Senator Charles Schumer, the NYSE’s strongest advocate in Congress, recently wrote to SEC chair Mary Schapiro to request more stringent regulations for ATS platforms. He also asked for development of a consolidated surveillance system for U.S. stock markets – and urged third-market systems help cover the costs.
No doubt ATS utilities will take some business away from major and regional exchanges here. The difference, hopefully, will be that Canadian regulators will be able to de-politicize their approach to these trading tools and let brokers finally solve the riddle of best execution.