Canada is experiencing a boom in alternative trading systems (ATSs) that is going to transform the behavior of the buy-side equity traders next year as they turn to technology to source liquidity.
According to a recent report by Toronto-based Competitive Metrics Inc., Canada is undergoing a dramatic shift from a dual market place structure dominated by the Toronto Stock Exchange (TSX), and upstairs block trading desks to more of a multi-market structure.

With five alternative execution systems operating right now, plus another three that are due to launch this year — Canada is undergoing a dramatic change in market structure, according to Jackie Chung, president of Competitive Metrics Inc., who authored the report, “2007 Buy-side Equity Trading in Canada: Exchange, Upstairs, ATSs, What’s Next?” The report is based on interviews with head and senior traders at 28 buy-side firms across Canada, managing C$1.2 trillion.

The study found that one in four buy-side trading desks execute 20 percent of their trades electronically. ”Some of these trades now to go to other places than the TSX such as Liquidnet Canada and BlockBook (an ATS from Perimeter Financial Corp.),” says Chung, who predicts the development of marketplaces is going to spur significant growth of electronic trading going forward.”

“Trading is no longer concentrated in the hands of a few major buy-side firms and is no longer gong to the TSX,” says Chung referring to the Toronto Stock Exchange, an electronic marketplace. “It could go to BlockBook, Liquidnet and new marketplaces that are going to be launched,” she says.

If all the alternative execution venues materialize, then Canada will have eight ATSs next year. Although the U.S. has more than 30 dark pools, this is significant since Canada is less than one-tenth the size of the U.S. market, notes Chung.

In the next year, nine out of ten buy-side trading desks plan to execute some of their trades on Canada’s alternative execution systems, said the study.

This is big change from 2005 when the only marketplace that buy-side traders had to monitor was the TSX. Even with Tradebook and ITG the trade would be executed on the TSX at the end of the day, says Chung.

In 2005, the date of 87 percent of buy-side firms were connected to electronic trading systems but very few firms used them. Electronic trading was concentrated n a few major buy-side firms, says Chung.

Still, over half or 52 percent of Canada’s equity trades are sent to brokers over the phone, while 46 percent is conveyed electronically and two percent goes via email.

Chung says that Canada’s shift to a multi-market structure will be a “natural catalyst for buy-side traders to embrace electronic trading with open arms.”

With the proliferation of new liquidity pools, they have to now monitor five or six different marketplaces, each having their own pricing and bid-asked spread, in addition to all the U.S. and global marketplaces they trade in, notes Chung.

“Suddenly there is an explosion of trading venues for them to manage. They can’t use pen and paper any more. They really have to turn to technology to keep pace with market movement and make decisions where to trade,” says Chung.

Up until a year ago, Bloomberg TradeBook and Investment Technology Group, which operated as an electronic broker, offered electronic execution but the orders could still end up being executed on the TSX. But in the past two years, a variety of electronic networks and alternative execution venues have proliferated to allow the buy-side institutions to anonymously match and execute orders electronically.

For example, Investment Technology Group formed a subsidiary TriAct Canada Marketplace that launched MATCH Now in July. Liquidnet Canada opened in 2006 following the success it had in the U.S. and Europe. Last May, seven of Canada’s leading investment dealers announced Project Alpha, an ATS initiative based a continuous electronic order platform that is supposed to launch later this year.

What will Canada’s equity market look like in 2008?
“2008 will likely be a year of fierce competition for order flow between the TSX and the alternative marketplaces,” and among the alternative venues themselves,” predicts Chung.

As competition with alternative venues heats up, buy-side traders in the study said the TSX wouldn’t be able to keep its over 90 percent-plus market share of Canadian electronic order flow. But since the TSX is one of the biggest embracers of technology and has made aggressive trading fee cuts, it will be a formidable competitor to the alternative venues in 2008,” contends Chung. In fact, TSX Group, which runs the Toronto exchange, plans to launch its own “dark liquidity” matching system, called ATX. Even if the TSX loses market share to the ATSs, electronic trading will attract more order flow and TSX will end up with a smaller piece of a bigger pie, says Chung.