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BNP Asset Management's Pojarliev discusses a variety of options to address foreign currency exposures. Although there is no single best-practice solution for addressing foreign currency exposures, institutional investors have three main choices, he says.

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March 1, 2002

Market Structure Massacre?

By Jim Marks

So what is the best way for institutional traders to approach the changes in market structure? The only obvious solution (assuming the changes will not be reversed), appears to be rooted in technology. Institutional traders will need more sophisticated trading software that enables them to conduct multiple tasks.

First, they need to be able to break up larger orders automatically into small ones with less market impact. Second, they need to aggressively use reserve or iceberg' order features of ECNs, automated exchange facilities, and order routing systems. These allow traders to post only a portion of their order, with the rest of the order automatically replenishing itself when the initial posted quantity is hit.

On the flip side, traders' software that can reserve peck' against ECNs and other automated trading facilities can discover where reserve quantities are hidden. The software should allow the trader to keep pecking at the reserve with automated trades until the reserve is exhausted. A trader needs an ability to run instantaneous models on a given order size against a snapshot of the market book to predict the market impact of an order. This allows a trader to make a more informed decision, to act quickly to maximize speed and certainty, or to follow more deliberate strategies. These strategies might use automated facilities or a phone. Traders need to make sure that their trading software accesses the full depth of the book from as many venues as possible with the minimum possible delay, so that the market does not appear fragmented.

These trading strategies, enabled by technology, allow the trader to actively respond to the changes produced by the new market structure. Unfortunately, the most common response to these changes has been a retreat to the passive solution of VWAP, where a trader is hoping to match the average price for the day. This is unfortunate, because this decreases the inputs into the price discovery process and produces less efficient markets.

Inefficient' Market

This is the ultimate irony: The structural changes designed to make markets more efficient may actually be making them less efficient. This should not be surprising, however. Markets are complex systems. Even small changes in complex structures can unleash more changes that are unanticipated and hard to predict.

In the theoretical work studying complex systems, this is known as the Law of Unintended Consequences. Some of these unintended consequences are felt as tighter spreads produce difficulties for funds executing large trades, as discussed above.

Another unintended consequence appears to be playing itself out on Nasdaq. In many ways, Nasdaq has been the largest target of recent market structure changes. Some it brought upon itself, as market makers invited new rules for handling orders because of their own trading practices in posting customer orders. It was an area that needed reform, and it culminated in the Limit Order Handling Rule in 1997.

The lesson that was learned, though, appeared to be that because this rule narrowed spreads, a further reduction in Nasdaq spreads would also be a positive step. It is too early to tell whether this is true.