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April 30, 2002

The Cause of Our Despair

By Seth Merrin

A dizzying pace of new market entrants and structures is underway.

Nasdaq trading has moved away from spreads to commission compensation while ECNs have garnered over 40 percent of Nasdaq's market share. The New York Stock Exchange is offering products for institutions only such as Institutional Express and DepthQuote, a step that begins the segregation of marketplaces between institutional and retail investors.

What's driving this pace of change? In large part, it is because the market structures do not respond to the demands of participants. As this occurs, problems become so large that entrepreneurs step in with innovations that attempt to solve the problems.

There are several macro events that have put enormous strain on the market structures. First, the equity assets in mutual funds rose nearly fourfold, from $1.2 trillion to $4.1 trillion, in the five-year period 1996 to 2001, according to the Investment Company Institute. Second, decimalization has created the adverse effect of reducing market depth. The quoted size on the NYSE declined 70 percent and by almost two thirds on Nasdaq since pre-decimal periods, according to a Dec. 3, 2001 report on market structure by UBS Warburg.

As a result, the shallowness in the market correspondingly reduces the size the institution is willing or able to show. That, in turn, reduces the average execution sizes on the exchanges. The size of an average trade on the NYSE fell by 30 percent in the period 1996 to 2001, from 1,489 shares to 1,041, according to Plexus Group. Nasdaq's trade size declined 43 percent, from 1,400 to 800 shares.

These macro issues have severely impacted institutional trading in general. They have also had a deleterious effect on the market impact, increasing transaction costs and volatility. These hidden transaction charges', can cost the institutions as much as $.46 cents per share, according to Plexus. In other words, for every dollar these institutions pay in commissions, they pay up to another $9 in market impact and other hidden transaction costs. Institutions have learned to compute these costs. While it is not an exact science, it is clear that the costs are real - and are growing. Actually, the nine to one ratio of hidden transaction costs to commissions has grown in two years from a seven to one ratio, according to Plexus. Reduction of trading costs is a critical factor in improving performance.

The current market structure perpetuates the rise in market impact and hidden transaction costs. For instance, when a broker receives a large institutional order, the broker tries to find a natural other side - to avoid a trade imbalance on the floor and to reduce market impact for the customer. This problem illustrates the two primary causes of market impact on many institutional orders. The first is information dissemination. The second is the size disparity between institutional order size and the average execution size on the exchanges. In attempting to find a natural for the customer and reduce market impact, information is disseminated through phone calls, AutEx advertising and FIX Indications Of Interests (IOIs).

Unfortunately for the institution, only 30 percent of all NYSE transactions are pre-arranged upstairs, according to information on the NYSE website. On the other 70 percent, advertising only serves to inform the rest of the marketplace that there is a large buyer or seller.

The last issue concerns market volatility. This industry is very different from all others in that there is no wholesale-only marketplace. Both wholesalers (institutions) and retailers (individuals) transact their business in the same marketplace. Within a single marketplace, there are no price breaks for the wholesaler; rather than receiving a volume discount, the institution pays a volume premium as previously explained.

A market can only determine fair pricing based on the supply and demand of information provided. Institutional traders are loath to share their entire order size with the market due to the adverse impact that information will have on the share price. The omission of institutional supply and demand data from the primary markets has rendered the pricing mechanism to be inexact at best. The primary market data reflects mostly retail supply and demand - not institutional.

It is the institutional size imbalance that interacts with the retail supply and demand that results in much of the market's volatility. By separating more of the institutional orders from the retail orders as the NYSE is beginning to do, the result should be less volatility in the primary markets.

Seth Merrin is CEO and co-founder of Liquidnet.