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Alternative Trading Systems

Alternative trading systems (ATS) are exchanges that operate parallel to and in competition with the traditional, established exchanges, or "old exchanges." They owe their birth to the extraordinary advances in electronic communication technology over the past 20 years and the explosive growth of trading volume.

In Canada, the old exchanges on which stocks and ETFs are traded are operated by TMX Group, a Canadian organization that is involved in a number of activities and that encompasses all the long-standing exchanges in Canada: the Toronto Stock Exchange for large-cap issues; the TSX Venture Exchange for emerging, small-cap companies; and the Montréal Exchange for derivativesfootnote 1 .

A large part of the daily trading volume is generated by institutional investors, such as mutual funds, hedge funds and pension funds, which trade large blocks of shares. So stock market activity largely involves institutions, which have lots of capital and which trade tens and even hundreds of thousands of shares, whereas the average individual investor buys or sells fewer than 1,000 shares of a given stock. Institutions, with their large block trades, can disrupt the normal functioning of the market.

Here's how:

If ABC stock (fictitious name), presently trading at $50 per share, is trending upward, 10,000 individual investors could decide, each independently of the others, to buy $5,000 worth of the stock. This would create 10,000 trades for $5,000 each. These individual buy orders would normally be executed without causing a ripple in the market, because of the small value of each individual trade and because each investor would probably place his or her order at a different time, thereby spreading the 10,000 orders over a period of time. Five thousand dollars divided by $50 per share equals 100 shares per investor. One hundred shares multiplied by 10,000 trades equals 1,000,000 shares, with a total value of $50 million.

Now imagine that there is a mutual fund XYZ (fictitious name) which is interested in ABC stock and that 10,000 investors decide to buy units of XYZ for an amount of $5,000 per investor. The investors are entrusting a single manager, the manager of XYZ fund, with a total of $5 million. The manager decides to invest this amount in ABC stock, presently trading at $50, and places a buy order for 100,000 shares. This block trade is much bigger than the 100 shares per individual investor. When the order reaches the market, there are many possible scenarios. To keep things simple, we’ll boil them down to three:

Best case scenario

The liquidity of ABC stock (trading volume when the order reaches the market) may be such that the order is easily absorbed and immediately executed at $50 per share. In addition, the market doesn't think the stock is rising, so the current holders of ABC stock are happy to sell their shares to XYX fund.

More realistic scenario

ABC stock may not be so liquid and only part of the order is executed at $50. The remainder is executed at a slightly higher average price, say $51. In addition, the market is uncertain about the future direction of ABC stock. The buy order for 100,000 shares tends to persuade the undecided investors that ABC stock is likely to rise. Consequently, the current holders of ABC stock become reluctant to sell their shares at $50, hoping to sell at a higher price.

Worst case scenario

Trading volume may be low because investors believe the stock is rising. Holders of the stock are waiting to sell at a higher price. In this case, the big buy order reinforces the idea that the stock will continue to rise; consequently, the price rises even more. Seeing the price move even higher, other investors who were thinking of selling become convinced that they can get an even higher price if they wait. At the extreme, a vacuum is created in the market: buyers are lining up to sell at ever-higher prices, but there are no sellers. This phenomenon, known as a liquidity black hole, has been known to occur in the futures markets; now it may become a reality in the stock market because of huge block tradesfootnote 2.

Our three simplified examples show the consequences of buy orders for large blocks of shares. The possibilities are the same for big sell orders. Here, the worst case scenario, the third example, is a downward spiral of ABC stock, which could cause other stocks to fall "in sympathy," resulting in an overall market decline.

The bigger the buy or sell order, the greater the risk of disrupting market prices and provoking an unintentional rise or fall in the market. Everyone is penalized in that case: XYZ fund ends up buying fewer shares than it wants to at the price it wants to pay, and when selling, the price will be lower than it wants, thereby reducing the fund’s return. The individual investor who wants to buy ABC stock is penalized because he or she will have to pay an artificially inflated price for the shares, and the investor who wants to sell ABC shares will have to sell them at an artificially low price.

The solution to these problems was the advent of alternative trading systems. The first ones were established in the United States in 19983. Their purpose is to offer their members, essentially institutions that trade large blocks of shares, the possibility of finding a suitable counterparty without disrupting the traditional market, thanks to the competitiveness and additional liquidity they create and the lower commissions they charge.

To survive, these new markets must offer better prices than the traditional markets; otherwise, institutional clients will return to the old markets. In this sense, the new markets compete with the old markets, which is a positive thing for the investing public, both individuals and institutions.

Alternative trading systems are essentially for institutions. Individual investors access them indirectly via mutual funds, pension funds and, in some cases, brokerage firms. In the latter case, the brokerage firm automatically sends the order to the market offering the best price.

In Canada, alternative trading systems have existed for a few years now. Here are the names and Web addresses of three of them:

Their websites show the success they have achieved and their goals. One gets the impression that stock markets as they have existed until now are undergoing a major transformation.

Investors who want to learn more about the subject will find on the site of the Securities and Exchange Commission (U.S. financial markets regulatory body) a 1998 document entitled Regulation of Exchanges and Alternative Trading Systems: Final Rules. Canada has very similar rules. The rules governing alternative trading systems are extremely stringent.

  1. TMX Group is actually composed of eight divisions, three of which are the exchanges mentioned. The other five are: NGX, for trading energy products (natural gas, crude oil and electricity); Shorcan, for trading fixed-income securities; Equicom, for investor and business relations; Datalinx, for market information; and CDCC (Canadian Derivatives Clearing Corporation), a clearinghouse for derivatives which plays an important role in derivatives trading by guaranteeing options and futures contracts traded on the Montréal Exchange.
  2. In many futures markets, this upward or downward price spiral is broken by setting a daily limit on the price advance or decline from the previous day's price (the technical names are limit up and limit down).

The author

Charles K. Langford

Charles K. Langford

PhD, Fellow CSI

Charles K. Langford is President of Charles K. Langford, Inc, Portfolio Managers. He teaches portfolio management at School of Management (École des Sciences de la Gestion), University of Québec (Montréal). He is the author of 14 books on portfolio management, derivatives strategies and technical analysis.

Until 2007 he has been vice-president overlay risk management for Visconti Venosta Teaspoon Approach Management, Ltd. Until 1990 he was portfolio manager for Refco Futures (Canada) Ltd.

He has received a Bachelor degree from Université de Montréal, a Master degree and the PhD from McGill University (Montreal); he is Fellow of CSI (Canadian Securities Institute).