The Ins and Outs of Crossing

Crossing trades is one way investment managers might seek to reduce execution costs on behalf of their clients. Traders also found crossing to be a way to tap hidden pools of liquidity and began using this technique in earnest in the 1980s. As a result, many institutional investors have to come to rely on this approach when executing large trades or portfolio restructures. Today, however, investors are examining the use of crossing for a variety of reasons.

To analyze this issue, Point of View spoke with two Northern Trust experts, Chad Rakvin, director, global equity index management, and Grant Johnsey, head of North America transition management and overlay services, about the role crossing plays in their clients’ trading strategies and when executing a cross may or may not be in the client’s best interest.

Point of View: Please give our readers a 60-second primer on crossing.

Grant Johnsey: A cross is a trade of a common security that is negotiated and executed between a buyer and seller outside of an exchange. This is usually accomplished through an electronic interface or through a broker. For example, a transition manager and an index manager may arrange a cross trade directly between themselves. By taking the opposite positions in the trade, they hope to reduce direct execution costs and minimize the market impact of that trade.

Chad Rakvin: There are two different types of security crossing trades — internal and external. Internal cross trades occur when investment managers match buy and sell orders within their firm, without a broker acting as an intermediary. When doing so, it is critical that the investment manager ensures that neither client benefits from the trade at another client’s expense. Although internal crossing can add liquidity and reduce commission costs, it introduces timing risks. Internal crossing is regulated and requires an exemption from the Department of Labor (DOL). According to the DOL, trades eligible for an internal cross must meet certain criteria and are executed at the market-on-close price.

External cross trades occur when an order (buy or sell) is matched with an outside counterparty. For external cross trades, traders use alternative trading venues such as electronic networks, dark pools or brokers as a source of liquidity to facilitate the other side of the trade. External crossing has the ability to execute intra-day, but even with electronic networks, an investor may have to wait to find a suitable offset to the trade, particularly for a large block. In addition, information leakage is a risk and can occur during the process of finding the other side of the trade.

Point of View: What are the benefits of crossing?

Grant Johnsey: As mentioned, because it precludes market trading, crossing can significantly increase liquidity. Commission costs can be lower in a crossed trade versus an open market trade. And with some electronic crossing systems that are anonymous, crossing can reduce information leakage, which is often a client concern as they execute larger trades or restructurings.

Point of View: Then, what’s the downside?

Grant Johnsey: Crossing is a passive trading strategy and may actually increase risk because the time of trade, and the resulting price, is determined by finding a counterparty with the offsetting trade. Consequently, crossing may result in less than optimum trade execution and actually increase total trading costs.

Chad Rakvin: Today’s higher trading volumes and lower commission costs on organized exchanges also make crossing less beneficial than it was many years ago.

Point of View: What’s the role of crossing in transition management?

Grant Johnsey: In a transition where plan sponsors change managers or rebalance assets, the transition manager must buy and sell a large number of names. This requires a high level of liquidity that can increase impact and spread costs. Transition managers use crossing to tap hidden liquidity to help defray these costs.

Point of View: Is crossing always an appropriate trading strategy?

Chad Rakvin: On the surface, crossing looks like a benign way of attracting liquidity and reducing costs. But once you delve deeper, you find that crossing is not always what it seems. Trading off-exchange carries risks. An external cross requires you to execute as soon as you find a counterparty, so the time and price of the trade is dictated by that counterparty regardless of whether or not that is the best price execution for a client. Because it’s uncommon for the seller and the buyer to have the same exact trade, there are most likely some concessions being made on one side of the trade or the other.

Grant Johnsey: Some clients want to cross because they are lured by the siren’s song of reduced trading costs, but in many instances they don’t consider the total cost of the trade. The total cost includes commissions, market impact and spread, as well as opportunity cost and volatility. The search for liquidity in a cross often results in execution delay and information leakage, so a cross can actually cost more than executing a smart trading strategy on-exchange.

Point of View: How do you determine when to cross?

Grant Johnsey: Every trading decision we make is based on the best strategy for the client. We actively strive to decrease the risk and total costs associated with each trade. We consider crosses and various liquidity pools as we trade. However, because crossing is by definition a passive strategy, you are relinquishing control of your portfolio to the counterparty. We look at crossing as an alternative that we will execute if it makes sense, but we never let crossing dictate our strategy.

Point of View: What are some other situations where crossing makes sense?

Chad Rakvin: We differentiate between hidden and exposed trades. Hidden trades are defined as only being known by the investment manager and the client, such as a funding trade. Exposed trades, such as an add to the S&P 500 index, is generally known to the street and attracts many participants, both active and passive. We advocate crossing with hidden trades where there is no volatility and little risk. Say, for example, that we have a client who wants to sell $500 million of an S&P 500 stock, and we have another client who wants to buy it. Because this is a very liquid trade with predictable volatility, we may decide to cross.

That’s the value our book of business gives clients: We can cross internally because we have sufficient volumes on both the transition and index management side of the trade.

Point of View: On the flip side, do you avoid crossing in certain situations?

Grant Johnsey: For transition assignments, we never purposefully delay a trade for the sake of crossing. This unnecessarily increases risk and relinquishes control of trading. We also believe that index changes are one of the worst times to cross because high volatility can drive up the total cost of the trade. Although crossing a sell order is easier because there are more active buyers, the trader may quickly become oversold and exposed to cash and therefore miss out on a portion of a market rally.

Chad Rakvin: Index trades, such as rebalances or ad hoc index adds and deletes, are exposed to the market and may attract speculative investors. Because index crossing must be done at the market-at-close price, exposed trades often experience exaggerated volatility and costs as a result of the number of market participants. For example, index additions that experience highly inflated prices may create the ideal opportunity to cross for a seller but the absolute worst time for a buyer. For index changes, we advocate a more thoughtful trading approach that seeks to create value for both the buyer and seller.

Point of View: So what you are saying is that when addressing these index events, Northern Trust focuses on maximizing liquidity instead of maximizing crossing. What are the benefits of this approach?

Chad Rakvin: Correct. Northern Trust utilizes a proprietary portfolio construction process in building our index-based products. The objective function of the trade construction and implementation process is to maximize liquidity and minimize total transaction costs related to the trade, while minimizing risk to the portfolio. Crossing is only recommended for hidden trades, not for exposed trades. We treat each index change event as a distinct event, rather than applying a rigid, formulaic plan.

Each change to an index has its own set of characteristics and requires a tailored approach that incorporates a disciplined risk control process and thorough understanding of the underlying liquidity of those securities. We believe this approach creates maximum value for all clients, on both the buy and sell sides.

Point of View: What role do broker-dealers play in crossing?

Chad Rakvin: Today, most crossing occurs on sophisticated systems that blindly match buyers and sellers, but broker-dealers continue to offer internalized crossing. Rather than using crossing networks, they find crosses and negotiate prices. The process may look like this: A sales trader identifies a list of sizable open trade orders and attempts to match the seller to a buyer from among their other clients. If they find a buyer, they negotiate the price and print the execution, typically in the third market. Both sides of the trade pay the broker a commission.

Grant Johnsey: Once they realized the potential revenues from charging commissions on both the buy- and the sell-side of a trade, broker-dealers became much more aggressive in marketing crossing. In fact, the crossing business became so lucrative that broker-dealers began offering discounted crossing to large investors so they could cross large blocks of stocks.

Chad Rakvin: A danger is that although the broker can complete this hidden type of cross with less market impact than trading in the open market, the process is not anonymous. The broker knows both sides of the trade and information can inadvertently leak into the market.

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