Few businesses have seen as much upheaval over the past few years as the stock-trading game. Now, with the prospect of a major new competitive threat from within, the Canadian trading business looks destined to undergo still more convulsive changes.

In early May, a group of investment dealers announced that they are getting together to build a new alternative trading system, currently known as Project Alpha. The new venture, which is expected to launch at some point in 2008, is being funded by the institutional investment dealer arms of the Big Six banks — BMO Capital Markets, CIBC World Markets Inc., National Bank Financial Ltd., RBC Capital Markets, Scotia Capital Inc. and TD Securities Inc. , all Toronto-based — along with the leading independent dealer, Vancouver-based Canaccord Capital Inc.

The primary target for this new system is clearly Toronto-based TSX Group Inc. , which has long been the dominant trading venue in Canada. The competitive threat from rival trading systems has been present for some time, but the ATSes that have been launched so far have typically struggled to attract volume. The notable difference with this potential competitor is that it can count on a significant level of internally generated volume right out of the gate, as the dealers that are behind the creation of the new ATS currently account for around half of the TSX’s trading volume.

Moreover, while the big banks and Canaccord are funding the new trading system, the intention is that it will be open to all dealers that want to join it as participating organizations.

Not surprising, the prospect of a new trading system with an inside track on about half the industry’s trading volume is being taken very seriously — not only by the TSX, but also by the entire industry, which could be affected by the introduction of such a formidable competitor.

One of the leading block traders, GMP Securities Ltd. , has not yet decided if it will participate in the new ATS. In a conference call to announce its latest quarterly results, Kevin Sullivan, CEO of parent company GMP Capital Trust, indicated that his company has been invited to join the new system, but it hasn’t decided whether or not to do so. Sullivan suggests that before GMP makes a decision, it has to study the various ATSes that are launching. And, at this stage, it’s very difficult to know what the impact of these new systems will be.

“There’s certainly many more than one new alternative trading platform being proposed in Canada right now,” he says, “and their exact impact, on the overall market, on TSX market share and on our business, is somewhat uncertain.”

At this point, there may be little that’s clear about the impact that such a serious new rival for trading business will have, but the one thing that dealers seem to expect is that trading costs will go lower as a consequence of the introduction of the new system.

Sullivan foresees possible benefits flowing from the advent of greater competition in the trading business, lower execution costs being just one. For guidance as to how a more competitive trading landscape is likely to change life for dealers, Sullivan notes that the only real precedent is the U.S. market, in which ATSes have garnered significant market share — as much as 30% — and have added liquidity to the overall market.

“We think that all of these new platforms will do the same in Canada. They will serve to add increased liquidity to the Canadian marketplace, which, ultimately, will be good for us,” he says. “And, we believe that execution costs are going lower — which has also been the U.S. experience — which will also be a positive for us.”

But not everyone is so optimistic. An executive at another dealer suggests that the development of various ATSes will only serve to fragment further the Canadian market’s already thin liquidity. Moreover, he points out, dealers will probably face increased costs as they try to meet their regulatory obligations to facilitate access to these competing markets.

Although some of the smaller investment dealers may be uncertain as to the ultimate impact a viable new competitor will have on the trading landscape, and on their businesses in particular, the goal of the big dealers seems to be to make trading more efficient and cost-
effective, one way or another. This strategy isn’t an original one — in fact, some of the world’s other established exchanges are facing the same pressure.

@page_break@In Europe, a venture similar to Alpha, known as Project Turquoise, is already underway among a group of major investment bankers: Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch & Co. Ltd., Morgan Stanley and UBS. And, various dealer-funded initiatives have popped up in the U.S., too — all with the goal of challenging the existing trading venues.

As Robert Greifeld, CEO of Nasdaq Stock Market Inc. , explained in a recent conference call with Deutsche Bank Securities Inc., this vulnerability to dealers starting their own ATSes is something that all traditional exchanges face.

“At the end of the day, the winners in the space are those people who can lever a fundamentally fixed-cost platform while delivering increased advantage to use it. Because if you’re not doing that, you have customers who have enough power that they can mobilize against you,” he says. “When you think about the competitive threats in the U.S. to the exchanges, it’s really just a proxy for the broker-dealers joining together, saying, ‘We think we’re paying too much’.”

That, seemingly, is what’s now happening in Canada. Yet it remains to be seen how well the gambit works. In response to other potential rivals, the TSX has lowered its trading fees and altered its pricing structure to defend its market share from these competitive threats, and it may well do so again.

“We continue to be leaders in reducing the cost of trading. This is what we do well, and what our customers can continue to count on in the future,” says Steve Kee, TSX Group’s director of media and marketing, adding that the TSX’s exchange fees are already among the cheapest in North America.

Indeed, analysts anticipate that the threat of Alpha could spur the exchange to deliver still more fee cuts, particularly to protect the revenue it generates from listing securities and selling market data.

Kee notes that the TSX does have other competitive advantages, such as proprietary products. And, he maintains, “[The TSX] will continue to provide the fast and reliable technology, [and] innovative products at competitive fees that will help ensure it remains the central point of liquidity in Canada.”

Certainly, starting as the dominant source of liquidity in a market that’s generally short on the stuff is a significant advantage. Moreover, it’s not a given that all of the big dealers’ volume will necessarily migrate away from the TSX. For one thing, regulators require brokers to ensure “best execution” for their clients. Given this requirement, Alpha’s brokers won’t simply be able to conduct all their transactions on the new ATS unless they are also meeting that obligation.

That said, the new system has clearly been conceived with an increasingly fragmented trading market and best-execution obligations in mind. The dealers’ initial announcement indicates that the new system will offer “a continuous electronic order platform where trading will occur on a price-time priority basis” and that it will ensure that trades entered in the system will execute on the best available market, including the current exchanges and ATSes.

“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,” Jos Schmitt, partner at Capital Markets Co. Ltd. (Canada) and CEO of the Alpha venture, says in a news release.

Also, the regulators are in the midst of expanding their definition of best execution, from simply meaning the best price for a trade to include factors that may affect the quality of execution, such as price, speed and certainty. So, it’s not clear how this more expansive definition will impact trading decisions.

Nevertheless, if the new trading system does indeed add liquidity, that may be its most significant contribution to the evolving trading landscape. While the TSX may cut its fees to defend its share of trading, those fees are already pretty competitive with markets in other countries, as are trading commissions. For example, data on all-in trading costs for 2006, published by Institutional Investor magazine, found that trades in Canada cost about 24 basis points to execute (including commissions, trading fees and market impact), down from 36 bps the previous year. This ranks Canada as cheaper than the Netherlands and Australia, but more expensive than France, Germany, the U.S. and Japan.

But the gap between Canada and the lowest-cost venue in the world, the U.S., doesn’t seem to be due to higher fees or commissions but to less liquidity. Looking solely at fees and commissions, Canadian trading costs are comparable with those in the U.S.; the difference comes in the market-impact cost of trading on the thinner, less liquid Canadian market. The market-impact cost was found to be more than 10 bps in Canada, compared with just five bps on the New York Stock Exchange and seven bps for Nasdaq.

Presumably, if the introduction of Alpha adds liquidity to the Canadian market, as some dealers expect, then the market-impact portion of trading costs may come down over time, too.

However, these costs might be under pressure with or without this nudge from Alpha. The TSX has already developed a new high-speed trading facility (known as ATX) that is designed to reduce the effect of large orders on prices. That system is awaiting regulatory approval. Assuming it’s granted, this new facility should address these market-impact costs that seem to dog the Canadian market.

Although cost is often front and centre in any discussion about competition in the trading business, it isn’t the only competitive issue for dealers and exchanges — speed carries an ever-increasing premium, too. With advances in technology, trading gets ever faster, and the performance standard for executions gets pushed steadily into ever-tinier increments (now measured in milliseconds).

Presumably, Alpha will be able to move shares at lighting speed. But the TSX has been working on this issue for some time, as well. Kee notes that in each of the past three years, TSX Group has spent more than $50 million on technology. As a result, along with initiatives such as ATX, it is working to optimize execution speeds for algorithmic traders. It is upgrading its hardware in anticipation of the introduction of new trading software (initially known as TSX Leapfrog, it is now being branded as TSX Quantum). The new software is due to start rolling out in the fourth quarter of this year, and is expected to deliver world-class trading speed. IE