Latest / How Canadian Markets Work / Episode 7: Alternative Trading Systems and Dark Pools

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Episode 7: Alternative Trading Systems and Dark Pools · How Canadian Markets Work

• 0:00
  Welcome in. Just go ahead and take a slow deep
• 0:03
  breath and settle in with us. Yeah, we are really
• 0:05
  going to lower the volume on all that frantic
• 0:07
  daily financial noise today. Exactly. Because
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  when you log into your brokerage app, you know,
• 0:12
  you look up a Canadian bank stock and tap buy.
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  There is this deeply comforting illusion of simplicity
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  at play. Right. It feels so direct. It really
• 0:22
  does. You picture your order just traveling smoothly
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  down some digital wire right straight into a
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  brightly lit room of the Toronto Stock Exchange.
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  You imagine it finding a seller, shaking hands
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  and just returning to your screen with a confirmed
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  price. The classic orderly marketplace. But what
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  if I told you your order might never actually
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  reach the TSX at all? What if, in the literal
• 0:44
  blink of an eye, it gets intercepted, routed
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  away, and executed in a completely hidden market,
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  like a venue that displays absolutely nothing
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  to the public? It really shatters that whole
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  illusion of the single orderly room, doesn't
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  it? We all like to imagine a linear world, but
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  the reality is a sprawling hidden architecture.
• 1:02
  It is. So welcome to today's deep dive into the
• 1:05
  source material. We are unpacking a fascinating
• 1:08
  stack of production notes and scripts from episode
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  seven of a financial series called How Canadian
• 1:14
  Markets Work, which is hosted by John and Jane.
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  And our mission for this deep dive is to gently
• 1:19
  pull back the curtain on that hidden plumbing
• 1:22
  of Canadian stock trading. Because it is an incredibly
• 1:25
  misunderstood landscape, right? Yeah. We're going
• 1:27
  to map out why this hidden architecture exists,
• 1:31
  the tradeoffs involved and why these shadowy
• 1:35
  invisible spaces might actually be the exact
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  mechanism protecting your retirement money right
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  now. Yeah, protecting it, not threatening it,
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  which is wild to think about. So let's start
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  by dismantling that old myth of the single exchange,
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  because for a very long time, that comforting
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  illusion we just talked about, well, it was actually
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  the reality. Right. One stock equaled one order
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  book. Exactly. If a Canadian company was listed
• 1:57
  on the Toronto Stock Exchange, you had to go
• 1:59
  to the TSX to buy or sell it. Full stop. It was
• 2:02
  a straightforward monopoly. And because they
• 2:04
  were the only game in town, they completely controlled
• 2:07
  the toll booth. They could just dictate the trading
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  fees. But eventually, regulators looked at that
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  and decided... Well, exchange monopolies are
• 2:14
  actually bad for investors. Yeah, they get inefficient.
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  There's no pressure to lower costs. So the regulators
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  deliberately broke the monopoly. They opened
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  the door to competitors, which are called alternative
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  trading systems, or ATSs for short. Right, ATSs.
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  So today, a massive Canadian bank stock that
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  is technically listed on the TSX is actually
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  being traded across several different Canadian
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  venues simultaneously. That's everywhere at once.
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  It is. I mean, think of it like a specific brand
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  of television, right? Imagine that exact TV being
• 2:48
  sold at a dozen different electronic stores at
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  once. The competition between all those different
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  stores drives down the retail price for you.
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  It drives down the trading fees. Exactly. And
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  it narrows the spreads. That's a really good
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  analogy. The arrival of these ATSs forced the
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  TSX to compete. And that did exactly what regulators
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  hoped it would do. But there is a cost to this
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  competition. Always a catch. Right. And the cost
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  is complexity. and market fragmentation because
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  now the liquidity for that one stock isn't pooled
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  in one big easily observable book anymore. It's
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  scattered. Exactly. It's divided across multiple
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  venues instead of sitting in that one unified
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  space. So if the TV is being sold at a dozen
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  different stores across town, how does the average
• 3:32
  person know they aren't just getting ripped off
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  at the specific store their broker happened to
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  send them to? Yeah. That is the big vulnerability
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  of fragmentation. But the Canadian market structure
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  has a very specific fix for this to protect the
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  retail investor. It's called the Order Protection
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  Rule. The Order Protection Rule. OK, so how does
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  that work? Well, it essentially dictates that
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  your order cannot execute at a worse price than
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  one that is visibly available on another marketplace.
• 3:56
  Oh, wow. So it's legally binding? Completely.
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  It is the patch for the fragmentation problem.
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  It forces this whole scattered complicated system
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  to act fairly. So the complexity of all these
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  multiple ATSs remains largely invisible and honestly
• 4:12
  pretty benign to the ordinary retail investor.
• 4:14
  Okay, I have to push back gently here though
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  because you said the order protection rule guarantees
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  I get the best visible price. Right. Visible.
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  But the source material specifically mentions
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  markets we can't see. So what happens when the
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  price isn't visible at all? Ah, yes. Now we cross
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  over from the lit markets, where everything is
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  displayed, to the much misunderstood world of
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  dark venues. The dark pools. I mean, just the
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  name sounds nefarious. It really does. It sounds
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  illegal. Yeah. But let's define them based on
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  the source text. In a lit market, orders are
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  visible to everyone. But in a dark venue, orders
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  sit invisibly and are only reported after they
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  execute. Right, after the fact. And I know that
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  sounds shady, but we have to look at the sympathetic
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  case for dark pools, the actual defensive purpose
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  they serve. Okay, lay it out for me. Let's look
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  at the specific numbers from the source notes.
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  Imagine a huge pension fund, right? This is ordinary
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  people's retirement money. And this fund needs
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  to sell two million shares of a midsize company.
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  Two million shares. That's massive. It is. But
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  that specific company only trades about 300 ,000
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  shares on an average day in the public market.
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  Oh, wow. OK, so if I'm at a poker table, right,
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  and I accidentally show everyone that I'm just
• 5:27
  absolutely desperate to fold, they're going to
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  use that against me immediately. Absolutely they
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  will. So if the pension fund posts a visible
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  two million share sell order on the lit market.
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  What happens? It's exactly like showing your
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  hand. The buyers get out of the way instantly.
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  They see that massive supply coming, so the price
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  drops immediately. And the pension fund gets
• 5:47
  a terrible, terrible price. And that's ordinary
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  people's retirement money taking the hit. Exactly.
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  Whose money is it? It's the pensioners. So dark
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  pools exist to prevent that. They allow computer
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  algorithms to slice up those massive orders into
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  tiny pieces and just let them rest invisibly.
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  Just waiting in the dark. Right. Waiting for
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  a natural buyer without broadcasting their intent
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  to the whole world and tanking the stock price.
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  OK. So dark pools are actually great for protecting
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  pensions. They're defensive. But I mean, if everyone
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  starts trading in the dark to protect themselves,
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  how does the market actually know what a stock
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  is worth? Yeah. And that right there is the structural
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  criticism of dark pools. Every order that executes
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  in the dark is an order that didn't contribute
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  to public price discovery. Because they're just
• 6:35
  looking at the lit market to figure out the price.
• 6:38
  Right. Precisely. Dark venues typically just
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  look at the lit market price to determine what's
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  fair for their hidden trades. But they contribute
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  absolutely nothing to forming that price. It's
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  known as the free rider problem. A free rider
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  problem. Yeah. If too much volume goes into the
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  dark pools, the public lit price is basically
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  being formed by a shrinking slice of actual trading
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  activity. The dark pools are just free riding
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  off the work the lit market is doing. Right.
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  But the source material highlights the Canada
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  actually handles this free rider problem differently
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  than other markets, don't they? They do. Canada
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  takes a much stricter line. To trade in the dark
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  in Canada, your order must provide what's called
• 7:16
  meaningful price improvement over the lit's quote.
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  It can't just match it. Meaningful price improvement.
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  So you have to actually beat the public price.
• 7:24
  Exactly. If you are going to bypass the public
• 7:27
  market and hide in the dark, you have to give
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  the investor on the other side a financially
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  better deal for the privilege. You have to pay
• 7:34
  a toll for being in the dark. That makes so much
• 7:36
  sense. It balances the whole thing out. It really
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  does. You know, bringing it all back to the listeners
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  actually life in their portfolio. Yeah. Because
• 7:43
  Jane's practical perspective from the source
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  text is just so grounding here. Yeah, Jane really
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  cuts through the noise. She does. Because all
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  of this market structure, the ATSs, the dark
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  pools, the fragmentation, it's utterly fascinating.
• 7:58
  But it can make ordinary people feel like they
• 8:01
  need to act on it or, you know, optimize their
• 8:03
  portfolio against it. Oh, they really don't.
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  No. So let me just speak to you listening right
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  now. If you are an ordinary long -term investor,
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  and you're just buying broad ETFs a couple times
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  a month, dark pools are simply not your problem.
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  I completely agree. The sources outline very
• 8:21
  clearly what you actually should care about.
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  And it's not sub -penny algorithmic routing.
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  It's high fees. It's poor asset allocation. Right.
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  And it's panic selling during a downturn. That
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  is what destroys wealth. This deep dive is really
• 8:37
  just about understanding the system so you don't
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  fear it. It's not about trying to outsmart algorithms.
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  Exactly. When you understand the plumbing, you
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  don't have to be afraid of the noises in the
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  pipes. That's a beautiful way to put it. Well,
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  as we wind down today, I want to leave you with
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  one final kind of provocative thought. Something
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  that builds on that free rider problem we just
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  talked about. Oh, I like where this is going.
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  Because if dark pools were relying entirely on
• 8:59
  lit markets to set the price, what happens in
• 9:02
  the future if dark pools become too successful?
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  Right. What if everyone goes dark? Yeah. If 99
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  % of all trading eventually moves into the dark
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  to avoid moving the market, then that remaining
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  1 % in the lit market is going to be solely responsible
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  for pricing the entire global economy. The burden
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  on that 1 % would be staggering. It would be.
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  Can a vehicle even survive if it's entirely made
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  up of free riders and has no engine left? It's
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  something to mull over the next time you tap
• 9:31
  buy. A really fascinating paradox to end on.
• 9:34
  Thank you so much for joining us for this deep
• 9:36
  dive into the source material. We hope this calm,
• 9:39
  slow look under the floorboards has given you
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  a bit more peace of mind about how your money
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  moves. Take care, and we'll see you next time.