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July 5, 2006

Bringing Back the Block: Brokers are offering capital to their best clients, and some like what the

By Michael Scotti

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The handling of large blocks of stock by human traders, written off as a dying art in this age of algorithms, may be making a comeback. Bulge-bracket shops appear more inclined to put their capital on the line to win back the higher margin block business and buyside desks have their own agendas. Wall Street's biggest firms want more of that institutional flow, and are willing to use more of their capital to get it. This strategy has coincided with an uptick in block trading over the last six months, traders anecdotally report. "The pendulum is swinging back to block trading," says David Briggs, global head of equity trading at Federated Investors. "We've driven down the costs of trading, and now we have to figure out how to capture alpha."

Another buysider noted: "Brokers are using capital to differentiate themselves. The block business is making a comeback."

The block business began to take a hit in 2001 when the New York Stock Exchange and Nasdaq required all trades be done in penny increments. Displayed liquidity subsequently dried up, practically forcing the sellside to feed its customers' orders into the market in piecemeal fashion with the use of computerized trading algorithms. Demand for old-fashioned human order handling plunged.

The Numbers

Data from the New York and Nasdaq illustrate the changes. In 2001, 48 percent of all volume traded on the Big Board was in blocks of 10,000 shares or more. Last December, only 27 percent was.

Protecting anonymity and avoiding market impact have been the key drivers in order routing practices in a low-volatility, low-return environment in recent years. Block trading was getting nudged to the side.

The buyside paradox-I want to see your size, but you can't see mine-helped to exacerbate the drop in block trading at a time when money managers-under pressure from mutual fund boards and institutional investors-were slashing commissions as their trading volumes were themselves plummeting. Brokers axed traders in the new economic reality of institutional trading, and gave the buyside the electronic trading tools that they had been using. The result: a rise in the use of direct market access and algorithms, which take big orders and make them look like retail orders.

"The SEC set up a market for retail-sized trades and then was surprised that all they got were retail-sized trades," commented one observer.

The growing popularity of trade-cost analysis has also handcuffed the buyside from making trading decisions that involve capital, said one head trader at a mutual fund. It might actually be better to pay up for stock and get a block done immediately, rather than whack away at a few hundred shares at a clip in an algorithm. The problem is that the scrutiny of mutual fund boards is hampering decision-making, particularly if the trade wasn't a good one in retrospect.

The tide may be turning, however. The rise in the number of big blocks traded after the close-spot secondaries-is a daily occurrence. Also, anecdotal evidence suggests money managers are reconsidering the sellside's block desk.

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