With alternative trading systems (ATS) proliferating around the world, seven of Canada’s largest investment dealers are planning to establish a new ATS that will pool their internal flows and increase the country’s equity trading efficiencies, the group announced on Thursday.

“With these seven broker dealers banding together to launch a single ATS for internalization, it’s going to make broker internalization in Canada more efficient than ever,” says Jackie Chung, president, Competitive Metrics Inc., a strategic research and advisory firm focusing on the Canadian financial industry.

The new ATS project, known as Alpha, is significant because of the size of the upstairs market in Canada and could pose a threat to the Toronto Stock Exchange (TSX), Canada’s main exchange, says Chung. An estimated 53 percent of the overall Canadian equity turnover is conducted through the TSX’s electronic order book, according to Competitive Metrics’ “2005 Buy-Side Electronic Trading and Best Execution in Canada Study” released in 2006. Traders participating in the study estimated that 47 percent of the trades are matched through brokers’ upstairs market but that is done inefficiently through phone calls, says Chung, citing the study’s results.

However, the traditional upstairs market is very inefficient since it’s done by telephone. “Now brokers are actually getting more automated and making internalization more electronic,” says Chung. By joining their separate pools of liquidity into a single ATS and moving in fractions of a second, that notoriously time consuming market will become very fast, she says.

The new ATS, project will contain a continuous electronic order platform where trading will occur on a price-time priority basis, according to Thursday’s announcement. The system will be designed so that trades are made on the best market available taking into account the current exchanges in operation and other ATSs’ being launched in Canada, stated the release.

The dealers include: BMO Capital Markets, Canaccord Capital Corporation, CIBC World Markets, National Bank Financial, RBC Capital Markets, Scotia capital Inc. and TD Securities Inc. The ATS is expected to launch in 2008 pending the required regulatory approvals.

The new ATS will be introduced under the National Instrument 21-101 (Market Operations), rule passed in 2001 by the Canadian Securities Administrator (CSA), which provides a way for organizations to set up ATSs in Canada. The rule was meant to foster competition with Canada’s one major stock exchange, says Chung. According to the release, the rules set out comprehensive requirements for order and trade reporting, information consolidation and market integration to ensure fair and transparent trading.

ATSs are already operating in the Canadian equity trading including Bloomberg TradeBook, Liquidnet ‘s electronic institutional block trading system that launched in October of 2006, and Perimeter Markets Inc.’s BlockBook. Meanwhile, Investment Technology Group is said to be working on TriAct Canada Marketplace, an ATS for TSX-listed stocks focusing on price improvement. (ITG announced the project in May of 2005, six months after the TSX closed the ITG- licensed POSIT crossing systems due to lack of order flow, recalls Chung.) In addition, Canada also has a new stock exchange, called the CNQ or Canadian Trading and Quotation System that is in the middle of launching its own ATS — Pure Trading, notes Chung.

“Our trading system will provide a seamless integration of trading venues so that investors in Canadian equities can enjoy the benefits of trading on a best execution basis in a multiple marketplace environment, stated Jos Schmitt, chief executive of the new ATS initiative in the release.

If the dealers integrate their liquidity pools into a single ATS, this will pose competition for the TSX. “If and when the broker-driven ATS is going to succeed, they would have less need to send trades to the TSX and much reason to send internal orders to a gigantic liquidity pool,” says Chung.

The brokers may have no choice but to introduce ATSs because they are facing pressure from clients who have been asking to pay less, says Chung. “The brokers are under tremendous margin pressure to do something to reduce costs and increase efficiency,” she relates. On top of that, global brokers such as Goldman Sachs and Morgan Stanley are setting up today in the Canadian marketplace.

“So, Canadian domestic brokers are under pressure due to clients and global brokers. Either they change in order to survive or they are going to be swept away by the currents,” says Chung.

While the U.S. market accounts for forty-five percent of the Morgan Stanley Capital International (MSCI) Index, Canada accounts for three percent of the world market cap. Since Canada is one-tenth the size of the U.S. equity market, proportionately if the U.S. has 30 ATSs, then Canada should have at least 3, the analyst says. “We have more than that, so arguably we are a marketplace that is ready for ATSs,” says Chung.

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