The growth of algorithmic trading is having a significant effect on Canadian capital markets and is the key motivating factor behind the planned launch of a new equity-trading exchange and technological upgrades at the country’s top bourse, TSX Group Inc.

Such trading involves the use of sophisticated mathematical models to identify and execute ideal trade opportunities. Computers search out the best trades available according to pre-set goals, such as breaking up large orders or seeking arbitrage opportunities. Used mostly by institutional investors, algorithmic trading accounts for about 15% of trade executions on the Toronto Stock Exchange and an estimated 30% of all executions in the U.S.

To capitalize on the growth, Canadian Trading and Quotation System Inc. , the Toronto-based exchange firm known as CNQ, will introduce Pure Trading, a new equities marketplace, in July.

CNQ says the new exchange, which will list all TSX equities and possibly TSX Venture Exchange issues as well, will use leading-edge technology to give investors — in particular, the algorithmic trading community — a “better, faster, cheaper” alternative to the TSX.

“Pure Trading will be world-class in capability,” says Ian Bandeen, co-founder of CNQ and its president and vice chairman. CNQ has been running since 2003 and lists about 50 small-cap issues.

For its part, TSX Group says it is fully capable of serving the needs of algorithmic traders and isn’t concerned about the launch of a rival domestic exchange.

“Our focus is on competing effectively with the New York Stock Exchange and Nasdaq. We think if we can compete with them, we can compete with anyone in the world, including domestically,” says Rik Parkhill, president, TSX Markets, a division of TSX Group.

In February, the TSX launched TSXpress, a series of system upgrades intended to increase trading speed by 50%, and ATX (alternative trade execution), an opaque trading system that matches orders with offsetting interest, minimizing the price impact on large orders. Both TSXpress and ATX, which will be implemented over the next six months, are designed to appeal to algorithmic traders. Parkhill says investors should expect further enhancements to TSXpress after the current round of upgrades are completed, but he didn’t elaborate.

Algorithmic trading requires top-of-the-line technology to handle the size and number of order messages coming through at lightning-quick speeds. A key driver in the growth of such trading is the large equity pools, such as pension funds, which often need to move big orders through the market.

“A rules-based or algorithmic system can take that order, break it up and spread it over the whole trading day,” says Tom McCurdy, a professor of finance at the Rotman School of Management at the University of Toronto. “Using an algorithm, a buy-side firm can evaluate quotes in the market and, when there is quite a bit of liquidity, it can enter a larger part of the order and execute it.”

McCurdy, who is also a founding director of Rotman’s financial research and trading laboratory, sees algorithmic trading as essentially a form of risk management. “It is seeking out the best average price for executing the order over time,” he says. “So, it’s really about improving the trading performance against some benchmark — the volume-weighted average price for that trading day, for example — as opposed to accepting the price in the market at the time the order was submitted.”

Algorithmic trading can also be used to seek out arbitrage opportunities, especially as more Canadian stocks become interlisted on multiple exchanges. McCurdy sees algorithmic trading as beneficial. “Managing risk efficiently is always good for the market,” he says.

In the U.S., alternative exchanges use cutting-edge technology and lean operations to attract business from algorithmic traders, among others, and they have been able to steal big market share from the major exchanges. Last year, the NYSE merged with alternative trading network Archipelago.

The CNQ’s Bandeen believes Pure Trading will be able to duplicate in Canada some of the success of the U.S. alternative trading exchanges. “Until Pure Trading, there hasn’t been a platform in Canada that could operate at the speed and with the performance the global algorithmic community is used to,” he says.

Parkhill says the conditions that made the NYSE and Nasdaq vulnerable to alternative trading exchanges aren’t present in the Canadian market, as the TSX has been proactive in upgrading technology and being responsive to its customers. IE

@page_break@