Cross Trade

A cross trade is a transaction in which the same intermediary stands on both sides: a broker or asset manager pairs one client's order to buy a security with another client's order to sell it, and executes the two against each other. The trade may never be exposed to other market participants, or it may be reported to an exchange only after the match is made. Cross trades are common in institutional asset management, where one firm runs many funds and accounts that hold the same securities.

The practice is lawful in most markets but tightly regulated, because the intermediary has a conflict of interest. It owes duties to both clients, yet the price it sets benefits one at the expense of the other. A cross trade is different from a wash trade, in which the same beneficial owner is on both sides and no real change of ownership occurs, which is a form of market manipulation.

When one portfolio needs to sell a holding that another portfolio under the same manager wishes to buy, sending both orders to the market means each pays its side of the bid-ask spread, brokerage commission and possibly market impact costs. Crossing the orders internally at a fair mid-market price can save both clients money. The saving is greatest in less liquid markets, such as corporate bonds, where spreads are wide and large orders move prices.

Typical situations include one fund receiving new money while another faces redemptions, index funds rebalancing in opposite directions, and transitions when a client moves assets between strategies. Brokers likewise cross client orders, particularly a large block trade, and operate crossing networks and dark pools that match buyers and sellers away from the displayed order book.

The risks arise from the intermediary's control over the terms.

• Pricing. If the price is not a fair market price, value is transferred from one client to the other. A manager might favour a fund that pays higher fees, or one in which it has its own money.
• Dumping. A manager might move an unwanted or hard-to-sell security from a favoured account into another that would not otherwise have bought it.
• Suitability. The trade must be in the interests of both parties, not merely convenient for the manager.
• Hidden charges. An intermediary that earns commission from both sides has an incentive to cross trades for its own benefit.

Managers are expected to record these risks in a conflicts of interest register and to control them through written policies, independent pricing and review by compliance staff. The duty of best execution applies to each client separately.

Several sets of rules apply. For registered investment funds, the Investment Company Act generally prohibits transactions between affiliated funds, but Rule 17a-7 permits a cross trade if it is made for cash at the current market price, involves a security with readily available market quotations, carries no brokerage commission, and follows procedures adopted by the fund's board. For investment advisers, the Investment Advisers Act requires disclosure and client consent where an investment adviser or its affiliate acts as broker for both sides, known as an agency cross transaction.

For pension plans, the Employee Retirement Income Security Act treats most cross trades as prohibited transactions, since the manager is a fiduciary to both plans. The Pension Protection Act of 2006 added a statutory exemption for large plans, subject to conditions that include advance authorisation by an independent plan fiduciary, execution at an independent current market price and regular reporting. The Securities and Exchange Commission has brought enforcement cases against managers that crossed trades at prices favouring one client.

In the European Union and the United Kingdom, cross trades fall under the general conduct rules for investment firms and fund managers: the duties to act in the client's best interests, to manage conflicts and to achieve best execution. Trades in shares must normally take place on a trading venue or through a systematic internaliser, and exchanges set their own rules for crossing orders, often requiring that the price lie within the current best bid and offer. Completed trades are subject to post-trade transparency and trade reporting.

The central safeguard is an objective price. For listed shares, the usual reference is the midpoint between the best bid and offer at the time of the trade, or the last sale price. For bonds and other dealer-traded instruments, managers take the average of independent quotations or a price from an independent pricing service. Policies commonly forbid crossing where no reliable independent price exists. Some firms route internal crosses through an outside broker or trading venue to obtain an independent check on the price.