Algorithms may have toppled the block trade from its perch as the dominant form of trading among large money managers, but the desire to get size done quickly persists in the heart of the buyside trader. To his good fortune, a determined group of brokers and exchanges is forever trying to meet his needs with new services or improvements on old services.
The present is no different. Bulge bracket players are touting direct contact with their trading heads. Third-market dealers are boosting their rosters of small- and mid-cap stocks. New block crossing pools are forming. Small-order dark pools are adding block-trading features. Exchanges are bolting on crossing systems.
As of last month, for example, the New York Stock Exchange opened a new front in its battle with upstairs dealers for block trades with its New York Block Exchange. The joint venture with BIDS Trading will work in conjunction with the NYSE’s displayed market and cater to those traders willing to compromise on price for immediacy.
Elsewhere, a dark pool birthed from third-market dealer Cantor Fitzgerald called Aqua Equities is catering to regional broker-dealers hoping to connect with money managers looking to trade small- and mid-cap names.
Bulge bracketeer Morgan Stanley offers high-level contacts on its trading desk to buyside desks provided they “open up” with their full trading needs. “Rather than just calling your direct coverage, or rather than just having the order working on the desk, the conversation may be with the head of trading or his or her lieutenant,” says Michael Schaftel, Morgan Stanley’s head of Americas Equity Distribution.
The block business isn’t as robust as it used to be, of course. Prior to the switch to trading in penny increments in 2001, blocks accounted for half of all trades at the NYSE. That meant about 550 million shares per day. Last year, block trades done on the New York floor comprised about 16.5 percent of all shares, or about 280 million shares per day on average.
Many players say the block market is mostly an upstairs phenomenon, anyway, and has been so for a while. They attribute at least some of the decline in NYSE block prints to the practice of printing the trades on the Nasdaq/FINRA Trade Reporting Facility (TRF). Nasdaq says it doesn’t know how many blocks in NYSE securities are printed there.
The data for Nasdaq-listed securities are complete, however. In 2000, a quarter of shares traded were done in block trades of 10,000 shares or more. That translated into about 430 million shares per day. During the first seven months of last year, block prints (mainly to the Nasdaq/FINRA TRF) account for 13 percent of all Nasdaq volume, or 255 million shares per day.
Blame algorithms for the drop-off in block trading. They have made the dearth of visible liquidity bearable in the post-decimalization world and are now considered highly reliable tools.
As for the future, algorithmic trading isn’t going away, say the pros, but neither are blocks. Algorithms are very helpful, they say, but not in all cases. The buyside will always have a need to trade quickly in size.
The continued availability of capital from the bulge shops has been a major question mark since the near collapse of Wall Street last year, but that too is expected to survive. Use of firm capital has gotten pricey given the extremely volatile stock market of recent months, but should come down once the markets calm down, sources say.
To check the pulse of the block business, Traders Magazine spoke with several participants. They shared their insights, as well as their plans.
The Bulge Trader
Michael Schaftel is head of distribution for the Americas in the institutional equities division at Morgan Stanley and is a member of the firm’s equity operating committee. Schaftel joined Morgan Stanley in 1994 and has held a number of management positions in sales trading and capital markets.
The buyside has always been frustrated, and it’s one of the greatest sources of frustration in the business: “Why’s it so hard to find the other side of the trade? And why won’t people open up?” We found that people have been more willing, particularly recently, to open up-whether that’s through a capital market conversation, or through our heads of trading. We’ve seen that business really grow nicely. Rather than just calling your direct coverage, or rather than just having the order working on the desk, the conversation may be with the head of trading, or his or her lieutenant, and you say: “I need to move $300 million of XYZ. Can you help me?” We may do that through risk, or we may do that through making a couple of select calls, or some sort of combination. But we’ve seen that business continue to grow over the last couple of years. …
Regarding talk of a reduction in capital commitment, I’m not sure what being a [commercial] bank has to do with capital commitment with respect to equities. We’re not in the warehousing business; we’re still in the moving business. We do provide a balance sheet to help people solve problems, and we price accordingly. I think the bigger issue about capital commitment in this market is really around volatility. The cost of capital has gone up, the price for liquidity has gone up, and the risk reward and potential complications for both parties have gone up. So, potentially, people say pricing is too high, or too low, which is just a function of the market. At 10 or 15 volatility, you could make a much tighter price than at 40 to 50. It’s just a much harder and unprecedented type of environment.
I think once the volatility dies down, the pricing will make more sense to clients. And when they manage their business on the buyside, it will be a more useful tool that will not necessarily have the same sort of headaches they may have right now. In a world where stocks are moving up and down-3, 5, 10 percent a day-the buyside trader could be really wrong. And the risk of being judged after the fact by a portfolio manager or an outside analytical tool could simply just not be worth it. That being said, capital commitment is a large part of any proper sellside shop. It’s not a panacea; it’s a tool to supplement the search for liquidity. We’ve competed with [commercial] banks for years, and they have always been large providers of capital in the equity world.
The Adaptive Trader
James Malles is head of U.S. equity trading at UBS Asset Management in Chicago. He has been a trader for the past 20 years.
We would all like to see more block trading. There certainly are not as many after-hours blocks initiated by buyside firms as there were-there were two or three a week a year ago. We would monitor these and see how big the discounts were. … In October of 2007, there were 13 block trades. All of them were buyside institutions, except for one private equity group. In May 2007, there were 18. We’re not seeing as many now, maybe only a couple a month. So that has really fallen by the wayside. When we do block trades during market hours, we’re doing more than half of them in Liquidnet, where our average execution size ranges from 50,000 to 100,000 shares.
In terms of capital from the Street, there is a broader range of block size. When we are working an order, we’re in the algos and chopping up an order, and you might find someone in a dark pool. [Block trading is] always a chicken-and-the-egg thing: Who wants to show their hand first? Obviously, you have to be careful about information leakage. … What typically happens is you’re reloading and working with a broker, hoping the other side comes in, but that doesn’t happen that often, either. October and November last year were unusual. When it looked like the world was ending, we were seeing some very large blocks for sale across all sectors. We [recently] haven’t had the volatility, and we haven’t had the same level of urgency to move blocks of stock that there was a few months ago.
We were seeing lots of 1-to-5 million share blocks for sale, and you could tell there was urgency. … I think that as traders, we have a pretty good range of options. I think the technology that is available is tremendous; the algos are great. I think we have good relationships when we need capital. Pricing is always the core issue and improvements are always needed on price.
The Ax
Ed Laux has been head of trading at Cantor Fitzgerald for six years. His previous assignment on the sellside was as head trader at ABN Amro.
As an upstairs block-trading house, when you have a lot of order flow in a particular name or a particular sector, you have a lot of good information. And if you’re doing some big trades, and have a few natural people, they tend to beget more people coming to you. Maybe it’s for that day, maybe it’s for a week, maybe it’s for a month. We try to make sure it lasts all year-that you become the ax in the stock. And if you’re doing a lot of trading in it, and putting up transactions, clients are forced to talk to their sales trader and find out what’s going on, so they can participate. That’s something that separated a lot of the third market from the bigger bulge bracket firms 10 to 15 years ago. The bulge bracket always had to go to the NYSE or Amex to do their trades.
But the third market guys were able to put their listed trades up in the third market. And unless you had volunteered that you might be a participant, you would get shut out a lot more in the third market. Where, in those days, the NYSE did so many of those blocks for trading down there, you could get yourself protection by putting an order on the book, or putting an order with a broker. Now that almost all block transactions happen in the third-market venue-it’s kind of like the old OTC market-the buyside trader has to speak up in many cases, or has to give the sales trader an indication or ask for some protection if we’re doing another trade so he can participate. Because, unless we know-and if we have enough participants to do a clean agency cross–someone who’s on the outside looking in is going to get shut out …
The block business is not a floor-based business anymore. It’s an upstairs business. There are still many, many blocks trading during the day, but now all of the firms, or many of the firms, including those that are NYSE members, can print those trades upstairs as a third-market trade. They don’t have to do the block-trade crosses on the floor of the NYSE anymore. That’s one reason that may account for the decline in the volume of blocks occurring on the NYSE floor.
The Exchange Guy
Joe Mecane spent several years running broker-dealer sales at UBS, soliciting retail orders for UBS’s wholesale group. He is now executive vice president for U.S. markets at NYSE Euronext, overseeing the just-launched New York Block Exchange, a joint venture between the NYSE and BIDS Trading.
Clearly, algorithms have gotten very advanced, especially in very liquid names. In general, they do a very good job because you can use algorithms that mask interest and get size done. Where people express frustration … The buyside is frequently looking for size and block liquidity in the second- and third-tier names, where it is harder for algorithms to function. The buyside is looking for a lower market-impact solution, and that is where the block-trading venues focus much of their services. In large-cap stocks, you can usually get a block trade done with limited problems.
Stocks that trade millions of shares per day aren’t the common trouble situations. It’s when you want to trade 100,000 shares in a stock that trades 100,000, 200,000 or 300,000 or 400,000 shares per day-that is where it gets much harder for algorithms to execute without having market impact, where the trade is a very significant percentage of average daily volume. So you have two choices. You can either drag that trade out over a longer period of time-get your 100,000 shares done over one, two, three weeks. People don’t like that because it increases the chance of information leakage. It could create market impact. Or you try to get that 100,000 shares done in a block. The BIDS joint venture is targeting people willing to accept some price impact in exchange for getting size done. What is unique about the joint venture is, it links together a dark anonymous crossing venue with the continuous trading that occurs on the exchange, and aggregates liquidity across those two venues. …
Assume the market is $10 to $10.05 and you have 100,000 shares to buy. Assume the stock trades 300,000 shares per day, so you presume you would have some amount of price impact. But let’s say you would be willing to buy 50,000 shares up to $10.15 as long as you knew you were going to get all 50,000 shares done. The joint venture allows for the concept of “minimum trade sizes”: “I will only trade if I can trade 50,000 shares, up to $10.15.” The joint venture’s technology continuously looks at the liquidity available at different price levels, both dark and light liquidity in the New York, as well as on the joint venture itself. As soon as it can aggregate enough liquidity to get the 50,000 shares done, it executes the trade. It is focused on aggregating liquidity within certain price parameters.
The Block Newcomer
Whit Conary runs a dark pool called LeveL. Originally geared for small orders, the system, which matched an estimated 59 million shares a day in November, is changing to become block-friendly.
We are adding a Smart Block order type to attract larger block-size orders to rest over a longer period of time. One of the best ways to do that is to give a customer the tools that will help him limit the number of executions he gets if the price begins to moves against him. The functionality of the order is very simple. If a trader is working a large block order, they can rest a piece of that order in LeveL. If the stock moves by a predetermined amount, the Smart Block order type will not allow a large piece of the order to execute. Basically, time-slicing logic will kick in after a predetermined price movement. The order type will have a trigger price set by the customer. The trigger price can either be a set price or a percentage of the price at time of entry.
If the price of the stock hits that trigger price, then executions up to a maximum amount also set by the customer will take effect. It’s going to slice the order up into time buckets, so a customer won’t get an entire execution at an inferior price. But he’ll still be able to accept smaller executions as the stock goes against him. This will also prevent gaming. The way you game the system is to send small orders in to find out if there’s a larger order sitting there at a price. You move the stock up, and then send in a larger order when the stock’s moved against the order that’s being gamed. What we’re saying is: Listen, we’re not going to let our customers get the largest chunk of their execution at the highest price. So, let’s say the stock’s trading at $11. You’re trying to buy it. At $11, you would own the whole thing. Let’s say it goes past $11.10. You set parameters that will say: I’m only going to accept 2,000 shares every three minutes. So, you’ll still be getting executions if there’s somebody in there. But you’re not going to get filled on your order at a higher level. …
We’re just providing a tool to give customers comfort around entering a larger block to sit over a longer period of time. We want to create the ability for somebody to rest a larger block to interact with some of that smaller flow, with the comfort of knowing that somebody can’t run the price on them and fill them at an inferior price.
The Aggregator
Lance Lonergan is head of sales trading at Weeden & Co. He is relatively new to Weeden, having spent much of his career as a sales trader at Citi.
About two-thirds of our block flows are crossed upstairs between clients and in various dark pools. The remaining third is executed in the displayed markets. With our OnePipe [aggregation] product, we access 30-plus dark pools on any given day, and the majority of those orders end up trading in 12 or 13 of those pools. But on any given day, it might be pool No. 30 where you trade a monster block. So you can’t count those less active ones out. The buyside has become very sophisticated in targeting a certain percentage of flow to execute algorithmically. The remainder of the flow that actually ends up on the trading desk is very desirable to trade in block form, if possible. There is less and less flow hitting a buyside trading desk that the trader is actually putting into an algorithm. The traders are expected to actually make those vitally important execution decisions and trade their blocks after processing marketplace intelligence. Most algorithmic trading is already carved out, and what is landing on the trading desk is definitely block-eligible. …
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.
The Regional Broker’s Advocate
Kevin Foley is best known as the former chief executive of the ECN Bloomberg Tradebook, where he was an active participant in the often contentious dialogue surrounding ECNs. Last year he took the helm of a small dark pool called Aqua Equities, which seeks to bring together traders at regional brokers and money managers.
It used to be that a trader at a large institution would speak to all of the bulge bracket firms but not all of the regional mid-tier brokers. None of the buyside shops speak to all of those guys. They speak to some, but they don’t all speak to the same ones. It used to be that if you didn’t talk to somebody directly, you could nevertheless interact with that guy’s liquidity on the floor at the NYSE or in the Instinet machine, if it was a Nasdaq stock. That has gotten more difficult to do. So if you don’t have a direct phone call into someone, it has gotten harder to find them if they happen to have the other side of your trade. Aqua addresses this niche. It makes it easy for an institutional trader to interact with the block liquidity of a mid-tier regional broker.
We make it effortless to harness that block liquidity if it is there. There is no effort lost if it is not there. We just use it on the guy’s desktop to filter information that goes to him. We can guarantee the broker that no one will ever see his information except a natural who is working the contra side. The buyside trader didn’t have to do anything. Typically, they have to give order flow to something. This is like “We will give you breakfast in bed. You don’t have to get out of bed.” From the point of view of the broker, it is like the perfect block call. He can’t get on the phone and only call people who are working the contra order; he doesn’t know who that is.
So it is a small effort on their part, but very, very efficient in terms of managing the flow of their information. It can only go to someone who has the potential to actually do a trade with them. …We are the only guys that pay for blocks. We pay a rebate that is the largest in the industry. We pay up to 45 cents per 100 shares, depending on the size of the trade. We pay a bigger rebate for a bigger trade. … Regionals tend to specialize in harder-to-trade names. We are not necessarily talking about the highest-volume names-we are talking about the ones they spend the most time on, the ones that they get yelled at the most over by their portfolio managers … Over 100 clients have signed up, both buyside and sellside.
The Innovator
Rishi Nangalia is global head of business development at Goldman Sachs Electronic Trading. As such he is responsible for executing the business objectives for the group’s REDIPlus trading platform, SIGMA/X liquidity strategy and the products and services that constitute the direct market access business globally. He joined Goldman’s equity products group in 2001.
X-Cross is Goldman’s first foray into moving upstream from child-level crossing. At conferences, panels and client visits, the elusive goal of block trading keeps coming up. The current product offerings have plateaued, upstairs volume has declined, the average trade size is down, and the average order size is up. Clients are willing to do more electronically, but they’re getting less done on a single-order basis. It’s a compelling reason for us to do something in the block space. Clients are telling us they want to do blocks, so we’ve come up with two new products: X-Cross and Block Signals. Both are integrated into REDIPlus and Sigma X. X-Cross is a point-in-time cross. We have one cross at 10:30 a.m. We’ll add another two in the second quarter, when we make a real product push and have more institutions with direct access to X-Cross. It’s for blocks, program traders, algorithms and those with direct access to X-Cross through FIX or REDIPlus, our front-end platform. …
Block Signals is a messaging product squarely focused on blocks. These are peer-to-peer messages. We’re beta-testing it now and are building up to a soft launch in February. The idea is that a trader puts a larger order into Sigma X. A community of people with firm contra-side orders gets messaged that there’s a large order on the opposite side. Traders can opt in on an order-by-order basis. Signals are only sent to the small community that’s relevant, and responding to that order generates more signals. The community is a select set of clients we choose. We monitor the behavior and performance of community members, such as how often they receive a signal, how they respond and what the hit rate is. Once they respond, there’s no discretion about whether they execute. And there are minimum sizes for execution based on the market cap of the symbol. We can do all this because we own the front-end and matching engine. We have 6,000 people using REDIPlus and we’d be happy to get 500 Signal users, including institutions, hedge funds and broker-dealers who have the size and intent to do blocks.
-Additional reporting by Michael Scotti, James Ramage and Nina Mehta.
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