Jared Dillian
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The Liquidity Problem

Maudlin Economics Jared Dillian examines stock market liquidity.

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February 16, 2009

Block Survivors

By Peter Chapman

The desire to block-trade has increased. One reason is that arrival price has become a popular benchmark. Firms have downgraded VWAP as a benchmark and focused more on implementation shortfall. There's a very high premium on one's ability to source liquidity in block form, close to your arrival price. Most of the time, execution statistics will be much better the sooner you can get that block to the tape. Therefore, your performance numbers will excel. ... In regard to trading blocks versus using algorithms, there's a premium for accelerating that execution and getting away from dragging out trades. ... We call it the "alpha decay" of the trade. The longer you wait to execute that trade, the more alpha decay you will have and the higher the cost of that trade, eventually. With an algorithm, you are more tied to the whims of the market. You are going to trade along with wherever that stock trades.

The Consultant

Bill Harts has had a long career automating the trading process, starting with a system built in the early 1990s for Shearson Lehman. Last year, he decamped from Banc of America Securities, where he headed equities strategy. He now runs his own consultancy, Harts and Co.

The business of facilitating customer block trading is way down. There are various reasons for that, but first and foremost, the big firms that were in that business have pulled back on the dollar amount and size they will commit to a particular trade. This is a time when firms want to lower their risk. That translates into prices for blocks that are not as aggressive as they once were. Concurrent with that is fragmentation of liquidity across all market centers. ... So today you can put that 100,000 shares into an algorithm and have it execute in smaller pieces. The origination of the order is still in block size-the portfolio manager has 100,000 shares. But she may no longer be as interested in getting it all done in one shot. If she is able to get it done in small pieces over a short period of time at a decent price, then that may be acceptable. ...

The hybrid market made it very difficult for people to get blocks done on the New York Stock Exchange. It severely impacted their block business. You used to have two brokers in the crowd and they negotiated the block price. One broker bid $20. Another offered $20.10. Then they agreed on the midpoint, $20.05. Post-hybrid, they turned to the specialist and he says, "$20.05? Sorry, the stock is now trading at $20.10." The market moved while they were negotiating. Therefore, they were not able to print the block in New York. Floor brokers, who are among the most ingenious and flexible market participants, got frustrated and were forced to find other ways to get business done, such as working blocks through algorithms on their handhelds. ... I've heard old-time block positioners disdainfully refer to algorithmic trading as "doing odd lots for hedge funds." People who think that way will probably not make it in the new world of trading.

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