Twelve of the largest trading houses have banded together to launch an electronic crossing venture. Will their clout make it the dominant system on the Street?
That’s the open question now that BIDS Trading has started operating. BIDS, which stands for Block Interest Discovery Service, was formed by the eleven largest investment banks (see table) and Knight Trading Group. It joins many so-called “dark pools” strewn across the trading landscape, but has the potential to become a blockbuster hit. BIDS’ backers collectively control nearly three-fourths of the industry’s share volume.
And after just one month of operation, BIDS’ volume was averaging between 11 million and 13 million shares per day. That’s put the start-up hot on the heels of the established players, which typically do between 30 and 50 million shares daily.
“Our investors want an efficient space for themselves and their clients to trade large blocks of stock,” BIDS chief executive Tim Mahoney tells Traders Magazine. “We think our model-open, flexible utility-is incredibly important.”
Mahoney should know. Before signing on with BIDS last September, he was head trader at Merrill Lynch Investment Management, an institutional investor with $100 billion in equities under management. There, he oversaw 14 traders and participated in the institutional traders advisory committees of both the New York Stock Exchange and Nasdaq. He developed strong relationships with the sellside, especially among the larger firms.
Block First
Tim was really one of the more thoughtful people about market structure,” says Michael Bleich, a BIDS board member and Lehman Brothers executive. “He was involved in the early experiments with some of the other crossing systems. He’s very knowledgeable.”
Electronic crossing has gone mainstream in the past year or two, as the number of platforms has surged. There are now about two dozen in operation. Most are owned by broker-dealers, either full-service or agency. Eight of BIDS’ backers operate their own systems.
The trading platforms can be broadly lumped into two categories. Half, which take a “block first” approach, are stringently optimized for trading large orders. The other half are more liberal vehicles that mix large orders with streams of small flow. The latter group includes most of the systems operated by the large full-service firms, including BIDS’s backers. These “flow-based” systems focus on high-frequency, low-latency trades. Execution sizes are often small.
BIDS falls into the first category. Its mandate is to offer brokers and money managers the ability to match large buy and sell orders using filters and screens that allow them to limit their counterparties.
The block-firsters can be further broken down into two groups: those operated by agency brokers and those operated by exchanges or broker consortia. Here, BIDS falls into the second category. These industry utility types are largely untested; none are more than a year old.
TABB Group, a Boston-based research organization, groups the players into three categories as well: block crossing alternative trading systems, broker-dealer internal markets and exchange crosses. It expects overall share volume on these platforms to grow from an average 512 million shares per day this year to about 1.5 billion shares daily in 2010. That reflects a rise in market share from 9.4 percent this year to 15 percent in 2010.
The Agency Brokers
At this point, success in the electronic
block crossing game rests with the platforms of three agency brokers: Investment Technology Group’s Posit, Pipeline Trading’s Block Board and Liquidnet. Each is doing about 50 million shares per day.
It is these players and the consortia platforms against which BIDS will be compared and judged.
Despite the muscle of its large backers, BIDS’ success is not a given. Its strong points include pricing, its industry utility approach and its backers’ control of order flow. But it offers nothing significantly new when it comes to features and functionality. It is also just starting the time-consuming task of connecting to all of its customers. Mahoney stresses BIDS is a multiyear project.
Yet while individual BIDS’ features are in use elsewhere, they may not be present all in the same place. Mahoney maintains his system is unique. He offers three reasons. First, it is open to both the buyside and sellside. A money manager must be sponsored by a broker, but it can access BIDS via algorithm or direct-market-access technology.
All three of the major block crossing networks let the buyside in yet none are particularly sellside-friendly. Liquidnet doesn’t let the sellside in at all. Pipeline and Posit do, but in the past year both have shut their doors to certain algorithmic flow following skirmishes over pricing and other competitive factors. ITG’s door has since reopened to brokers’ algos used by the buyside. Pipeline’s is still largely closed. Its stance has particularly upset the big brokers.
An official with one of BIDS’s backers who did not want to be identified says that in light of the Pipeline incident, the utility model is a better solution. “We invested in BIDS because it appears it will become an industry utility much like the model of a stock exchange,” the exec says, “and since we are a key player, we thought we should be a part.”
A Sellside Place
BIDS is not the only utility gearing up to offer the sellside an efficient place to trade blocks. Nasdaq, some sources contend, is likely to offer BIDS its stiffest competition when it launches a continuous matching service later this year. The exchange recently launched a periodic cross. Others include the ISE Stock Exchange, which integrates a midpoint match service with a continuous market, and the New York Stock Exchange, which plans to launch an intraday periodic cross in August.
BIDS is open to all brokers, not just its 12 backers. Some will likely use BIDS to liquidate their “customer facilitation positions,” BIDS officials say. These are positions taken on when committing capital for customer orders.
For their part, money managers may find using BIDS is an attractive way to both trade blocks anonymously and pay their research bills at the same time, BIDS officials say. The buyside still largely pays for its research with commission dollars. That forces buyside traders to direct most of their flow to the brokers that supply their portfolio managers with research. Many would like to trade more often in systems such as Posit or Liquidnet but are constrained by the requirement to direct their orders elsewhere.
With BIDS, the buyside can have its cake and eat it too. A buyside trader sponsored by Merrill Lynch, for example, can negotiate a commission rate with Merrill that permits it to trade in BIDS and pay Merrill for its services, too.
“Customers tell us they would trade in a system more often if they were able to credit different brokers with those commission dollars,” Bleich says. “BIDS is open. The buyside can use whatever sponsoring broker it wants.”
Paying for Research
One buyside trader notes this approach might be a good way to pay a broker for research with whom he might not otherwise trade. “You can start crediting those brokers that you don’t trade too much with that way,” says Dennis Fox, head trader at Munder Capital Management, a Michigan-based shop with about $30 billion under management. “It might become a more useful product.”
Many buyside traders already are killing two birds with one stone. They use so-called “aggregator” algorithms provided by their brokers to surf multiple dark pools. A fill in a dark pool will lead to a commission payment to the broker that can help reduce the research chit.
In any event, BIDS officials believe, about 70 percent of the orders entering BIDS will ultimately come directly from the buyside via broker algorithms or direct-market-access platforms. They stress that it is a difficult number to predict, but expect the split to be at least 50-50.
BIDS’ second selling point, according to Mahoney, is its structure as a low-cost utility. The ATS operator plans to charge its broker-dealer customers just enough to cover its operating costs and no more. Its base rate is less than a half-cent per share, according to Mahoney, but it will charge even less to high-volume users.
BIDS’ Bargains
BIDS’ rates compare favorably with those of some of the more popular crossing networks operated by agency brokers. Those can reach two cents per share. However, BIDS’ rates are still higher than those charged by exchanges and ECNs. Those entities typically charge no more than three-tenths of a cent to take liquidity. They also typically pay traders to supply liquidity.
BIDS’ pricing was a key factor in winning over trading houses agonizing over declining profitability. Pressure from the buyside has pushed commissions sharply lower in recent years, forcing brokers to find ways to keep costs down. The solution has been to replace human traders with computers and invest in small stock exchanges and ECNs to counteract the pricing power of the dominant exchanges.
The buyside is likely to pay more than the sellside to transact in BIDS, as their commission will be split between their broker-sponsor and BIDS. The differential is similar to what prevails with competing systems. A buyside trader might pay Pipeline, for instance, a cent to trade, while a broker would pay a half-cent. With BIDS, the price to the broker may be a half-cent, but the broker would likely charge his customer three-quarters of a cent or a penny per share for an algo trade, for example.
BIDS’s third selling point, according to Mahoney, is its flexibility in the way it permits users to trade. Traders can opt for automatic matches at the midpoint of the national best bid and offer, or they can enter into text-based negotiations with potential counterparties. Also, they can use either firm or conditional (not firm) orders.
That flexibility, though, doesn’t come without strings. The more wiggle room a system offers, the more trouble a trader can potentially get into. The danger could be exacerbated, if the system is open to the sellside.
At least that is the philosophy of Liquidnet. The well-regarded dark pool has only opened its door a crack to the sellside, with its H2O service. Liquidnet does not allow brokers into its community out of fears of manipulation and their differing agendas. The concern is that the sellside sharks will eat the buyside minnows for lunch. Based on that, it is still an open question whether or not the buyside will even want to swim in the BIDS pool.
Take It or Leave It
ITG and Pipeline let the sellside in, but they only permit firm orders and do not allow negotiation. All Posit trades are done automatically at the NBBO midpoint, while Pipeline’s are within the NBBO. Pipeline also requires high minimums for executions. All these factors serve to protect the buyside trader from predatory behavior.
BIDS most resembles Liquidnet. It allows “conditional” orders and negotiation. Those factors can make it a more treacherous environment in which to do business. Conditional orders are a boon for the trader who wants to be both in BIDS and elsewhere at the same time, but they also make it easier to “fish” for information. Opportunists can trade on that information to the disadvantage of the source. At the very least, a trader using a conditional order can simply walk away from a trade.
Bargaining Pitfalls
Negotiated trades between a buyside and a sellside trader offer their own pitfalls. The buyside trader may just want to get the trade done quickly, while the sellside trader might be adamant about getting the price he wants. “Once you get beyond the simple midpoint match,” Lehman’s Bleich explains, “you must be sensitive to who you are trading against.”
In any event, Mahoney is confident buyside traders will want to trade in BIDS. The exec maintains that today’s buyside trader can hold his own with any sellside trader. Compared with, say, 10 years ago, the buyside trader is considerably more sophisticated and adept, Mahoney says. He works with similar tools and may even be a former sellside trader.
“The buyside is a very smart and sophisticated group of people that is growing exponentially smarter every year,” Mahoney says. “Their tools are getting better. They are doing more trades on their own.”
Munder Capital’s Fox isn’t too worried about the sellside. He doesn’t want to be gamed, but feels he is able to deal with it when it happens. Plus, it could just as easily be a hedge fund doing the gaming. “I don’t differentiate,” he says. “If someone is going against me, they are going against me. They may be buyside or sellside.”
Loaded for Bear
BIDS’s customers will not be trading in a vacuum. They will be armed. They will be able to dictate a minimum trading amount, for example. They will also be able to limit the types of people with whom they are willing to trade. Using filters, they can screen out those traders who don’t complete their trades. They can also screen out those users of conditional orders who rarely enter into a trade.
“Each time someone comes into BIDS,” Mahoney explains, “we track his behavior. We especially look at how often a conditional order firms up when invited to do so.” Liquidnet uses similar filters and scorecards.
Mahoney and his crew-BIDS has a staff of 20 in New York-have been out meeting with the largest money managers on the Street, but are not pushing too hard at this point. The firm is testing its system with its sellside backers to get them used to the platform before steering money managers toward it.
BIDS’s backers may also take a low-key approach when it comes to marketing to the buyside. Lehman’s Bleich says his organization wants the buyside to trade with it, but is not planning to favor BIDS over other systems when courting the buyside.
“We will do events where we put BIDS people in front of our clients,” Bleich says, “but it is more of an educational process to help them understand how different dark pools work.”
History
Aside from the issues confronting buyside traders in deciding whether or not to use BIDS, there is also the question of how much use BIDS’ sellside backers will get out of the system. Despite their lock on a huge portion of industry flow, there is no guarantee it will get shipped to BIDS. Bleich says Lehman’s traders are likely to treat BIDS on par with its own internal crossing system, LCX, and other market centers. “You’re going to go where the liquidity is,” Bleich says.
Certainly history shows that bringing brokerage houses together around an innovative trading platform doesn’t automatically guarantee success. In the late 1990s, several of the major trading houses came together to form the ECNs Brut, which stood for Brass Utility, and Strike. Strike never gained any traction, and Brut was a nonstarter for years. It topped out at a 10 percent market share before being acquired by Nasdaq.
The true test of BIDS’s viability may come later this year, when Nasdaq rolls out its own continuous cross. Like BIDS, Nasdaq will operate its cross as an industry utility, possibly charging around one-tenth of a cent. Besides price, Nasdaq will have at least three other advantages over BIDS: its huge liquidity pool into which the cross will be integrated, its widespread connectivity to traders, and market data revenues it can share.
Nasdaq recently launched a periodic cross, but says the continuous cross is what customers really want. “That is the endgame for the crossing network,” says Brian Hyndman, senior vice president in transaction services at Nasdaq. “That is what customers want.”
Whether it is what the large brokers that invested in BIDS want remains to be seen. Yet if the liquidity is in Nasdaq’s dark pool, they will have little choice but to go there. At the end of the day, with an increasing number of look-alike dark pools on the scene, it may be price that drives business. In the words of BIDS’s Mahoney: “Low-cost marketplaces attract the most volume.”
Market Cap Conudrum
Large-caps? Mid-caps? Or small-caps? What kind of flow is BIDS likely to see?
Tim Mahoney, BIDS’ chief executive, expects to service the whole range. He thinks large-caps will be more prone to be automatic trades at the midpoint of the national best bid or offer. Small- and mid-cap trades will most likely be negotiated.
The more popular crossing systems have found the most success with small- and mid-caps, though. Very liquid large-caps are typically traded on exchanges and electronic communications networks. Why should BIDS expect to see any large-cap flow? Mahoney maintains that efficient pricing is the key there. Crossing networks charging 2 cents per share can’t compete against ECNs charging 2 cents per 100 shares. BIDS charges less than half a penny per share.
Made in Canada
BIDS is the brainchild of Alberta Market Solutions, a small software company based in Calgary, Canada, founded by six employees of the now-defunct EFA Software. EFA built several electronic stock exchanges for nations around the world until 2002, when competitive pressures did it in.
With their open-for-all-to-see order books, the world’s electronic stock exchanges have proved efficient mechanisms for trading small orders. But they are less suitable for trades of very large blocks or illiquid securities that require more secrecy. The six technologists took that lesson with them to AMS and spent the next four-and-a-half years developing BIDS.
