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April 3, 2008

Picking Up the Pieces

Traders Deal with Fragmentation of Marketplace Liquidity

By James Ramage

The scenario sounds simple. You're an institutional buyside trader who just got an order to sell 100,000 shares of an illiquid name at a specific price as soon as possible. Where do you begin?

Maybe 10 years ago you'd have shipped it to the New York Stock Exchange floor, where for decades 80 percent of all of its shares traded. But because the market's now far more fragmented, just under 40 percent of listed stocks trade there. So, do you execute it yourself or call a broker?

If you handle it yourself, as more of the buyside is, you're faced with a plethora of choices. You could look in the giant buyside-only dark pool, Liquidnet, and try to find a counterparty there. You could cut the order into pieces and use algorithms, smart order-routing and direct-market-access tools to send them around to the 40-odd dark pools to search for an anonymous match, or to the ECNs, or to Nasdaq or the NYSE. Through your algos you can check some of those dark venues simultaneously, but not others. And what if you call a broker? Do you think he can do a better job sourcing liquidity? Do you ask him to use capital? You have a wealth of liquidity options all offering the potentially perfect solution for executing your block order, but you're finding that it's still not easy to get it done. And the whole time, the clock is ticking.

Big Board Blues

Call it Fragmentation 2008. This is a re-creation of a previous theme. The first market that subdivided itself into multiple competing venues was the Nasdaq market in the 1990s. As a result of the Nasdaq price-fixing scandal, the number of ECNs, with the blessing of regulators, mushroomed.

Today, it's the market for NYSE-listed securities that has fragmented. As a result of the Securities and Exchange Commission's Regulation NMS, half the trading in NYSE names now occurs in venues other than the Big Board.

And because institutional investors are much more likely to own NYSE-listed names than Nasdaq names, this new bout of fragmentation is especially acute. By some estimates, three-quarters of institutional money managers' orders are in NYSE names; the balance is mostly in Nasdaq stocks.

Making fragmentation different this time is the presence of so many crossing systems, or dark pools, which affect liquidity for both Nasdaq and NYSE-listed names. For many traders, this is the real problem: So much liquidity is hidden in systems operated by upward of 40 broker-dealers and exchanges.

Fragmentation affects traders in two ways: by (1) reducing the amount of information available and (2) making it harder to trade blocks.

In a recent survey conducted by Traders Magazine covering 126 buyside firms, the major trading problems associated with fragmentation are slower fills and bad prices.

It's a Problem

In the survey, 80 percent of the respondents call fragmentation a problem. Not all agree on the magnitude of the problem, though-34 percent call fragmentation a "big" problem. Another 46 percent say it is a "small" problem. The remainder say it is not a problem.

When asked if fragmentation affects their portfolios' performances, the numerical breakdown is similar. Three-quarters say fragmentation affects performance and, consequently, returns to investors-from pension funds down to mom-and-pops.

Still, some say fragmentation has benefits-that fragmentation helps keep trade costs low, spurs innovation, facilitates anonymity and brings flexibility (see sidebar).