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April 30, 2002

The ECNs Special Advantage

By Wayne Wagner

Market making is generally simple in the retail world.

With the exception of time intermediation and affirmative obligation, a computer can easily conduct a trading forum in this market. ECNs have done it. But it's another matter for institutional orders.

Institutional orders are very large. Over half of the institutional dollars traded come from orders that exceed a full day's volume, according to a Plexus Group study. Eighty percent of institutional dollars traded derive from orders exceeding a half-day's volume. These giant orders can easily overwhelm any procedure-oriented trading venue.

The table below shows that trading volume exploded when large institutional investors commenced trading of large positions.

Small orders blend into the daily give and take, but the volume more than doubles the day after a major institutional trade is begun. The orders over one day's volume were only 7.5 percent of the orders submitted. Still, they represented 80 percent of the total dollars traded. The larger the order, the larger the gain in resulting market volume. It is known how the order initiated, but where did the other side of the trade come from?

The classical market model doesn't apply when some of the transactors are (a) very large relative to ordinary flow; and (b) imbalanced toward buying or selling. Put simply, institutional liquidity is not there for the taking. Somebody needs to take actions that draw liquidity to the market. That person is a market maker.

A market maker naturally accumulates information about past, current and possible future buying and selling interest: the market maker is information-central' about trading interest in a stock. The market maker supplies a layer of intelligence on top of the trading forum.

Some readers of Traders Magazine may be surprised at the trading magnitudes indicated in the table above. Orders of institutional magnitude are seldom seen on the streaming transaction tape because they seldom meet another trade of equivalent size. Thus these orders often are assembled in the market from a large number of smaller pieces, and the information-central trading interacts with the trading forum activity.

Unlike orders in a classical market, these orders dominate not only because of size but also because they represent well-informed opinion. From the market maker's perspective, massive trade size combines with informed opinion. This means market making tasks of time intervention and affirmative obligation are complicated and hazardous. An expanded market maker's role as information-central' is essential to the trading of these orders.

There are two ways to expand liquidity, but something has to give. It will be necessary to relax either the "when you want it" clause or the "at low cost" portions of the liquidity definition.