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March 23, 2005

The Future of Block Trading

By Peter Chapman

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The pace is slowing, but the volume of institutional order flow bypassing block desks at U.S. brokers continues to grow. That's the upshot of a new TowerGroup report about trends in direct market access. Tower estimates that one-third of institutional volume was traded via front-end systems last year. That's up from 11 percent in the first year of the decade.

That's not good news for brokers. They've been able to fashion DMA as a service by virtue of their memberships on Nasdaq and the various exchanges and by providing the software. But commissions are low. DMA trades earn them only a penny per share versus a nickel for traditional worked orders. The numbers look even worse when algorithmic trades are included. TowerGroup estimates that another seven percent of share volume is flowing self-directed through brokers' algorithmic trading servers. Tower counts those trades separately because the commission structure is different. Self-directed algorithmic trades earn brokers two cents per share.

The Tower report does predict a respite for brokers from the rapid run-up in direct market access. The consultancy forecasts growth in DMA this year at nine percent, slowing next year to 5.5 percent. Those numbers compare to double-digit growth in each of the first five years of the century. That silver lining for brokers comes with a caveat. The trades that do land on brokers' block desks are likely to be the tougher ones, according to the report. That may not be healthy for desks' profitability.

The Tower report was authored by Dushyant Shahrawat, a senior analyst in Tower's securities and capital markets practice. Shahrawat has been with the consultancy since 1998, covering buyside order management systems, offshore outsourcing, Linux and Web services and other areas.

Traders Magazine technology editor Peter Chapman interviewed Shahrawat.

Traders: One-third is a lot of order flow.
Shahrawat: It took a lot of time to put that number together. We did that very gingerly. Nobody seemed to have the breakdown although we talked to some very large buyside firms. Two of the top five money managers in the world didn't even have a very good idea as to how total buyside order volume breaks up by strategy. They had back-of-the-envelope analysis. So aggregating was quite a challenge. It could be off, but no more than five to 10 percent.

Traders: How much of that is hedge funds and how much is traditional money managers?
Shahrawat: About 55 percent is hedge funds and 45 percent is long equity. But that is changing. For two reasons. First, most of the upswing in trading volume from hedge funds is behind us. The hedge fund market will not grow by leaps and bounds as it has over the last three to four years. Also, long equity management firms are continuously automating. Their percentage of the total DMA market will probably start to inch up. I wouldn't be surprised if that 55/45 split is reversed.

Traders: You report that Morgan Stanley's split is 60/40 hedge fund/traditional.
Shahrawat: Right. That comes directly from them.

Traders: Within the long equity category, where do quants stand?
Shahrawat: DMA is about 30 percent to 40 percent of their trading. It's not tremendously high.

Traders: But still higher than that of a mutual fund?
Shahrawat: No question.