How do cross trades work, and why are they so controversial?

What are cross trades?

Cross trades refer to offsetting the matched buy and sell orders for a similar asset without recording it on an exchange. Since they are not registered, big exchanges do not allow this kind of activity. However, these cross-trading activities can become legal if a broker executes the matched buy and sell orders for similar security in different client accounts. How? They need to report them on an exchange so they can be recorded.

Citing an example

Let us explain this using a scenario. Let us assume that Mr. A wants to sell and Mr. B wants to buy. The broker will think that this situation perfectly fits each other. So, the broker feels that it makes sense not to send these orders to the stock exchange. Instead, he fills them as a cross-trade. He only reports them after the transaction. This is done in a timely manner. When we say timely, we mean that there will be a timestamp containing the cross trade’s time and price. Cross-trade executions should be based on the current market price.

If the buy and sell order that involves a derivatives trade perfectly matches, brokers can take cross trades as an option. Hedge on an options trade that is delta neutral is an example.

If the orders match, why do exchanges prohibit cross trades?

If a buy and sell order matches, it makes sense to just execute it right away without sending them to the stock exchange to be filled. It’s easier! However, no matter how sensible it may sound, major exchange stresses that they do not allow this practice. If the trades are not reported on an exchange, clients will not see if there are better deals. The clients will not know whether the price they got was better or worse than the current market price, which may be available to other market participants involved in the cross-trade. So, major exchanges encourage traders and brokers to send orders so they can be recorded.

On the other hand, in some instances, cross trades are not too bad of an idea. If the buyer and seller have the same asset manager and the cross-trade price looks decent and competitive enough during that time, this cross-trade may not be too bad.

The manager’s responsibilities

Cross trades are simple. If a portfolio manager wants to eliminate an asset from one client’s portfolio, he can simply move it to another client’s portfolio, provided he agrees. The manager and broker need to assure the clients that the market price is competitive. They also need to record the cross trade so that it will have a proper regulatory classification. Finally, the asset manager should prove to the SEC that the cross trade was reasonable and benefited both clients.

So, should I agree with a cross trade if I ever encounter it?

There are possibilities that you will encounter cross-trade opportunities. Others are skeptical about them because they undermine the market trust. It’s true that some are legal but ensure that you interact with those orders. Another reason why others criticize cross trades is because of “paint the tape.” It refers to a market manipulation where market participants try to influence a security’s market price by buying and selling among themselves. They do this so that it looks like there was a massive trading activity. This market manipulation is not legal.

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