Last Updated on 3 November, 2022 by Samuelsson
In trading, certain practices and actions of the brokers lie at the border between legal and illegal. One of such practices is cross trading, which involves buying and selling securities off the public order book. Now, you may be wondering what cross trading means.
Cross trading is a practice where buy and sell orders for the same security are executed without recording the transaction on an exchange. Most exchanges do not permit cross trading, but it can be legally executed when a broker matches a buy and sell for the same security for two separate client accounts and then reports the trade as a “cross trade” on the exchange.
In this post, we will have a look at cross trade and what it means. To help you understand this topic, we will discuss it under the following headings.
- What is cross trading?
- What is the purpose of a cross trade?
- How a cross trade works
- Who is cross trading for?
- When are cross trades permitted?
- Cross trade example
- Drawdown of cross trade
Cross trading definition: what is cross trading?
Cross-trading is a practice, in most brokerage firms, of executing identical buy and sell orders for the same security without reporting the trade on the exchange. While it is usually not allowed on most exchanges, cross trading can also be legally implemented when a broker executes identical buy and sell orders for the same security for different clients’ accounts and then reports the trade them on the exchange.
For instance, if a client wants to buy and another client wants to sell, the broker would pair the two orders without recording the transaction on the stock exchange to be filled. But filling the orders as a cross trade before recording the transactions after the process — but in a timely fashion, and recorded with the time when the cross-trade took place.
However, the cross-trade must be executed at a price that is the same as the current market price at that particular time. Cross trades are usually performed for trades involving identical buy and sell orders that are connected to a derivative trade such as hedging on a delta-neutral options trade or similar derivative.
Cross trade should not be mistaken for matching orders. A matching order is a situation where a broker receives an order to buy stocks of a certain company at a specific price point and a sell order from another client for that same stock at the same price. Since the orders are identical, the broker will simply exchange the security between the two clients – this is allowed in some countries only. However, in other countries, the broker must go to the exchange floor and declare the intention of purchasing the stocks at the specified price and ask if there’s any objection. If there happen to be no objections about the transaction, the broker will then go ahead to buy the stock, after which the broker will then offer them to the client at the same price. The broker will benefit from this by charging a commission for the trade and the two parties involved will benefit from the fast execution of their trades.
What is the purpose of a cross trade?
Just like with a limit order which specifies a particular price point for a trade to be executed at or near, cross trades have almost the same purpose but with a clearly defined rule. One of the rules includes trade must be executed only at the specified price and not near or after. Traders can take advantage of this opportunity (buying and selling securities at their own specific price point) instead of joining the public order book.
Traders who want their orders to be filled at a fixed price point (and not floating) take advantage of this method of trading but have to pay the price of waiting for an exact order on the opposite side of theirs to be executed. Also, the problem of having to pay commission in form of a spread is eliminated since their orders are being filled by the same asset manager of both clients.
How does cross trading work?
Cross trades are allowed only in selected conditions like when both the buyer and seller of the same security are clients of the same asset manager and the price of that same security is perceived to be significantly competitive at that particular time of trading.
An asset manager can successfully execute a buy and sell order for clients and transfer their assets between them and eliminate the spreads on the trade. The asset manager and broker must agree to a fair market price for the trade before recording it as a cross trade for proper regulatory categorization.
However, the portfolio manager must also prove to the Securities and Exchange Commission (SEC) that the transaction was beneficial to both clients.
Although cross trades do not require investors to give a specific price for a trade to be executed, identical orders happen when a broker receives a buy and sell order with the same price from two different investors. Trades of this nature may be allowed (depending on the local regulations) since the investors have shown interest in making a transaction at a specified price.
This may be more applicable to investors who trade in a highly volatile market where the price of an asset experiences huge swings within a short time frame.
Cross trading has been the subject of controversies over the years because they seem to weaken the level of trust in the market. While it is not tagged as an illegal practice, some trades are technically legal but the problem lies with the inability of other market participants to interact with those orders since they are not recorded. Market participants may have wanted to take part in the transaction but were unable to because those trades occurred off the exchange.
Another blighting concern is that cross trades may be used as a smokescreen to manipulate the market illegally whereby the price of an asset is been influenced by investors who create the illusion of high trading activities like wash trading, pumping and dumping, and other illegal practices through buying and selling of securities within themselves.
Who can make use of cross trading?
Traders involved in cross trading do not have to specify the price point for a trade to be executed, but a trade can only be completed when a broker receives a matched buy and sell order from two different clients for the same security.
Cross trade is more relevant to investors who trade volatile securities because of the swings experienced in the price within a short period. It is not suitable and available to the common investor since most will shun it — the average investor does not trade in an illiquid market that is more prone to volatility than the liquid market and does not have to wait for a matched order of the same security before execution.
Situations where cross trading is permitted
Cross trades are not permitted on most exchanges and even when they do allow it, certain conditions must be met before such trades will take place i.e. both the buyer and seller must have a matched order in other for the broker to execute it. And both parties must be managed by the same portfolio manager. The price of the asset must be seen as competitive in the particular period for it to be permitted.
Furthermore, to eliminate the issue of spread in regular trading, an asset manager can easily transfer one of the client’s assets to another that wants it. The trade must be executed at a fair market price and then recorded as a cross trade legally following the regulatory categorization.
The portfolio manager or broker is required to show the exchange that the cross trade was beneficial to both market participants.
Some other conditions for cross trades to be permitted are listed below:
- Cross trades are permitted as a hedge to derivatives trade.
- Cross trade can be carried out for certain block orders.
- A broker need not record the transaction on any exchange when transferring assets of clients between accounts.
Cross trading examples
Here’s a hypothetical trading scenario. Let’s assume an investor, say investor “A”, wants to sell a particular security — let’s call the security “XYZ”, while another investor, let’s call this one investor “B”, wants to buy it both at the same price. A broker can easily pair these orders without the need to record and report the transaction to the stock exchange for it to be filled. But Instead, the orders can be executed as a cross trade, and the broker reports it promptly and time-stamped it with both the time when the trade took place and the price of the trade of both sides without charging a commission for it. Trader A and trader B both get what they want at the desired price and without any delay.
To be seen as technically legal, the cross trade must be executed at the specified price that corresponds with the current price of the security at that particular time when the trade took place.
Or the other way around, say trader “A” wants to buy security “XYZ” at $200 and trader “B” has exact order to sell at $200. The portfolio manager or broker in charge of both client’s accounts can then match these two orders together but is not obligated to report this transaction to the exchange to be filled but instead will just transfer “XYZ” between the account of trader “A” and trader “B” and then record it as a cross trade together with the time and price the trade took place.
The drawdowns of cross trade
Cross trading may be beneficial to investors who involve in it but it comes with its pitfalls. It may be due to a lack of proper recording because when trades are not recorded, both investors may not have the opportunity to buy or sell at the prevailing market price of the security which is readily available to non-cross traders.
Cross trades orders are by nature never listed or recorded on an exchange, therefore, investors may not be aware as to whether a better price was available for their trade to be executed thereby missing the opportunity to trade at that particular price.
Unlike trades on the order book, a trader can not set stop-loss and profit targets while engaging in cross trades. This can have a devastating effect on a trader’s portfolio since the price of a security may experience gaps and swings during trading hours which may result in loss of the trader’s investment.
Another concern to cross trading is that it can be used to manipulate the market by creating an illusion of high trading activities (fake volumes) on particular security whereas these orders are just taking place between two clients of the same asset manager. And market participants may have wanted to participate in these same orders but did not have the opportunity to do so because these trades were not listed publicly, this makes the transaction somehow unfair and shady to the public.
Trading has evolved from the age of ticker tape and the era of order book trading which is a slow method. The advancement of technology has brought significant changes to the trading world. However, to every good side of trading, there’s always a loophole sneaky investors will take advantage of to defraud the public.
Investors can benefit from cross trades through the quick execution of their transactions and in most cases without paying commission to the broker. However, it is not an acceptable practice in some countries which requires that all orders must be reported to the exchange before execution.
Cross trades are welcomed by few investors, and they can be profitable when done properly and very helpful to investors who are looking to trade in a highly volatile market. Cross trading should be used responsibly by investors to avoid the legal consequences that come with using it inappropriately.