Understanding Cross Trades: Explanation, Legitimacy, and Concerns

What Is a Cross Trade?

Cross trades occur when buy and sell orders for the same asset are offset without being recorded on an exchange, a practice not allowed on most major exchanges. However, when brokers match orders across different client accounts and report them, cross trades can be legitimate. While convenient for asset transfers and derivatives hedging, cross trades can bypass public orders, leading to potential market trust issues. Understanding their mechanics and implications is crucial for both investors and brokers.

Understanding the Mechanics of Cross Trading

Cross trades have inherent pitfalls due to the lack of proper reporting involved. If the trade isn't recorded on the exchange, clients might not get the current market price. Because the orders aren't public, investors might not know if a better price was available. Cross trades are typically not allowed on major exchanges. Orders need to be sent to the exchange and all trades must be recorded.

However, cross trades are permitted in select situations, such as when both the buyer and the seller are clients of the same asset manager and the price of the cross trade is considered to be competitive at the time of the trade.

A portfolio manager can transfer assets between clients and remove the trade spread. The broker and manager must show a fair market price and properly classify the trade. The asset manager must be able to prove to the Securities and Exchange Commission (SEC) that the trade was beneficial to both parties.

Exploring Risks and Controversies in Cross Trades

Cross trades don't need a set price from investors, but orders match if both list the same price. Such trades might be allowed by local rules if both investors agree on the price. This may be more relevant for investors trading highly volatile securities where the value may shift dramatically in a short period of time.

Cross trades are controversial because they may undermine trust in the market. While some cross trades are technically legal, other market participants were not given the opportunity to interact with those orders. Market participants may have wanted to interact with one of those orders, but were not given the chance because the trade occurred off the exchange. Another worry is that cross trades can be used to 'paint the tape,'' manipulating market prices by faking high trading activity. ' 

The Bottom Line

Cross trades involve matching buy and sell orders for the same asset without public exchange recording. While not permitted on most major exchanges due to transparency concerns, they can be legitimate when executed by brokers for different clients at competitive market prices. These trades present risks, such as lack of market price visibility, and can potentially be used for market manipulation. Investors should ensure proper disclosure and adherence to regulations when involved in cross trades.