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September 30, 2004

Building the Better Mousetrap?

By Peter Chapman

That minimum, plus not disclosing the order's side, lets Pipeline open its service up to both the sellside and the buyside. Institutional traders have typically been leery of playing in the same sandbox as the brokers. The worry is that the sharpies will take advantage of the information inherent in the buyside's large orders.

"We believe we've achieved the right balance of giving some information," Federspiel says, "but without giving way enough information that enables predators to play the games they play in other markets." Pipeline says it has signed up almost 40 desks-two-thirds are buyside.

For an order to be eligible for a trade it must be deemed "reasonably priced" by the system. To that end, the ATS calculates a price range within which a large order can reasonably expect to trade. A Pipeline order that falls within that range is good to go.

The range is determined by aggregating fills in the public market into 25,000-share lots; calculating the highs and lows of the last five of these lots; and then calculating averages of the two extremes. The result is a synthetic bid-ask spread.

On a recent day in September, for example, Cisco was quoted at $18.84 to $18.85. Pipeline's analytic was $18.83 to $18.87. A Pipeline order for Cisco of between $18.83 and $18.87 would be reasonably priced.

Pipeline execs maintain most orders will be pegged to the midpoint of the market's best bid-ask spread and come with a hard limit. Most are likely to execute at the midpoint. "At Pipeline, we encourage people to come in at the middle," explains Federspiel. "We're not focused so much on price discovery, but liquidity discovery."

A buyer, for example, who prices his merchandise at the midpoint is thought to be more concerned about getting a big block off his desk than he is with fighting for every last penny. A less aggressive buyer would likely peg the bid.

While executing trades at the midpoint sounds fair, it is actually fraught with peril. Unscrupulous traders have been known to "hijack" the public midpoint when using one prominent ATS. A trader with an order in a blind ATS which crosses at the general market's bid-ask midpoint will post a small quote in the general market to influence the spread. The tactic gets him a better fill in the ATS.

To prevent such shenanigans, Pipeline actually calculates its own bid-ask midpoint. If it detects any funny business, such as an abrupt widening of the spread, it ignores the change until it sees a print. All orders pegged to the midpoint in Pipeline are actually pegged to the Pipeline midpoint.

A trader can leave his order in Pipeline for two seconds or all day. That way traders can dump orders in Pipeline for extended periods while they work others in the general market. The service is complementary, Federspiel maintains, to the day-to-day practice of slicing-and-dicing orders through brokers.

"You can only shred so many different thousands of shares at a time," the inventor says. "The others you can put in Pipeline. Let it sit there. See if there is a large natural."