This is part of an 53 page article on Anonymous trading.

Abstract

We study the role of anonymous orders on the Toronto Stock Exchange (TSX), a market where identity disclosure is voluntary. The users, information content and impact of these orders on prices and liquidity are examined, as is the potential use of anonymous orders to conceal proprietary trading activities such as front running. We find that anonymous orders account for approximately 10 percent of orders in the market. Large anonymous orders appear to be information- rather than liquidity-motivated and have a larger permanent impact than non-anonymous orders of equivalent size. On a market-wide basis, there is no evidence of the systematic use of anonymous proprietary orders to front run client orders, although a small number of brokers may be more likely than others to use anonymous orders to trade ahead of their clients. This may be useful as a point of reference for further regulatory investigation.

1 Introduction

The use of anonymous orders and trades in securities markets is an important microstructure design decision that has significant implications for market liquidity and integrity. It is therefore of considerable interest to exchanges and regulators, particularly with electronic limit order markets where complete anonymity is possible, compared to interaction on the trading floor or OTC markets (O’Hara (1995)). The trend in equity markets in recent years has been largely toward greater pre-trade anonymity. Many exchanges today have completely anonymous electronic order books, such as the London Stock Exchange’s SETS and Germany’s XETRA, which co-exist alongside non-anonymous trading platforms. Euronext Paris, the Tokyo Stock Exchange and the Australian Stock Exchange removed broker identifiers from orders over the period 2001 to 2005. A small number of exchanges, however, do continue to require pre-trade identity disclosure in varying degrees. The Hong Kong Stock Exchange requires identity disclosure for all orders; however, this is only displayed to brokers. The Korea Stock Exchange also displays the identities of the top five brokers (by volume traded) in each stock in real-time. Some exchanges allow the option of identity disclosure in specific trading platforms or segments of their respective markets, such as Nasdaq’s SuperMontage, and the London Stock Exchange’s IOB segment. The Toronto Stock Exchange (TSX) allows brokers the option of whether or not to disclose their identities on their orders on a single trading platform, with disclosure as the default setting. There is considerable debate surrounding the merits of anonymity in equity markets. Some arguments in favour of greater pre-trade anonymity are that it: (i) allows informed and institutional investors to conceal their trading intentions from the market, thus preventing parasitic trading or front running by other traders; (ii) reduces the migration of orders to other trading venues where anonymity is allowed; and (iii) fosters a more level playing field among dealers by improving price competition and discouraging collusion around quote setting (Madhavan (2002), Simaan, Weaver and Whitcomb (2003)) .

On the other hand, identity disclosure offers investors maximum transparency and informativeness. Such disclosure facilitates “sunshine trading”, where traders advertise their interest or activity in a security to mitigate adverse selection problems and execute large orders with reduced price impact (Admati and Pfleiderer (1991)). Moreover, identity disclosure is argued to prevent the concealment of inappropriate behavior such as frontrunning and breaches of client priority rules (Garfinkel and Nimalendran (1998)), although to our knowledge this issue has not been investigated empirically.

Concerns over the implications of reduced transparency on market integrity are of particular concern to regulators and warrant closer empirical examination. In 2003, the Tokyo Stock Exchange removed broker IDs from orders following complaints from fund managers that proprietary traders used the information from identified trades to anticipate the activity of institutional investors, resulting in adverse price movements for the fund managers.1 In 2005, Canada’s Market Regulation Services Inc. (RS) undertook a major review of the handling of large block orders in Canadian equity markets after receiving front running complaints from several market participants. Although no evidence of systematic front running or substantive client priority violations was found, one concern raised by buy-side firms was the lack of transparency surrounding anonymous trades.

Front running is the illegal practice of a stockbroker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers. When orders previously submitted by its customers will predictably affect the price of the security, purchasing first for its own account gives the broker an unfair advantage, since it can expect to close out its position at a profit based on the new price level. The front running broker either buys for his own account (before filling customer buy orders that drive up the price), or sells (where the broker sells for its own account, before filling customer sell orders that drive down the price).