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August 11, 2008

Old Standby Returns

Color gets new lease, but don't call it a comeback

By Brian Pears

Having recently moved to L.A., I've been thinking more about the ocean lately, particularly about waves. They fascinate me. They often break on the beach with a violence that belies their calm nature in open seas. I also see waves in our industry right now. The past five years have been akin to a tremendous swell crashing violently on shore.

The industry has been tumbled upside down in the break. Quite literally, in fact, with the buyside-sellside relationship turned so topsy-turvy.

But many in the industry are taking a second look, as some recent stories in the press have indicated. Average commission rates have seemingly bottomed out. The industry has moved toward tiered structures, paying less for commodity executions and much more for value-added trades. This has happened in the midst of the dark-pool revolution. As the number of non-displayed venues (and tools to access those venues) has exploded, many traders have become overwhelmed with choice, and are beginning to ask for more visibility in trading.

We are coming to a collective realization that the recent wave of change we've endured momentarily submersed a powerful tool in a trader's tool belt-color. The ability to discern market color and to use it as an integral part of a best execution process has always been a must-have for the professional trader. But traders had eschewed color in the rush to try out the latest electronic gadgetry, and with good reason, given the impressive creativity on display in so many of those new tools.

But color is making a comeback.

Color can imply many things, so I'll define what I mean. I'm not talking about research or news on a stock, or technical analysis, or rumor. All of those may be components of color, but color, as classically transmitted on Wall Street, is more than all that.

Color is the who, the what, and the why of a block trade. Discovering the answers to these questions, to whatever extent possible, allows a trader to formulate the where, when, and how of an execution. Those decisions form the basis of best execution, in fact.

Any discussion of color seems to lead quickly into a discourse on leakage, or the improper use of information that results in a detrimental execution (at least, from the perspective of the person whose information was leaked.) In talking about what color truly is and how it fits into a holistic best execution process, we can also define and compartmentalize leakage as well.

Let's break down color's component questions. The who is the most frightening to traders, especially at the biggest institutions. While one can say that the who can contain information about brokers and venues that have an axe in a name, in the minds of these elephantine firms, the who can also include the leakage of their firm's name, which is taboo.

Likewise, the why can be a tricky question to answer. Clearly, there is a tremendous difference between a fund trimming a holding to manage cash and a fund someone is selling because they almost slipped in a pool of leaking hazardous waste while visiting the company's manufacturing plant. The more unique the why, the less likely a trader wants to share it with the marketplace.