Editor’s Note: Where is block trading headed? That was the driving question behind our inaugural conference, “Traders Live: Block Trading in an Electronic Era.” The idea was to stick to a topic for a full day, drilling down into the nuances of block trading. Below are some of the highlights from the September 27th conference. But first, some background to put the conference into context:
Block trading has taken a powder in recent years. The average trade size on the New York Stock Exchange has plummeted to just over 300 shares, roughly one-fifth the average
trade size five years ago, when decimalization began. When the minimum trading increment went to a penny, traders began hiding their orders to protect themselves from predatory traders. They displayed less liquidity, first by using floor brokers for listed stocks, and later with technology, using algorithms that chop large orders into hundreds or thousands of smaller ones. This cut the amount of block trades-individual trades of 10,000 shares or more at the NYSE-nearly in half. Consequently, the role of the sales trader and position trader changed as fewer orders went through upstairs trading desks.
Crossing networks or dark pools-undisplayed markets-are now busy trying to automate as much of the upstairs block trading business as they can. This has changed equity trading and the way traders transact. As more of these pools were launched, fragmentation became a problem. These technological advances occurred at the same time the economics of equity trading changed: Lower commissions have put additional financial pressure on Wall Street brokers and money management firms. Buyside shops responded by cutting their brokerage lists. This allowed them to better leverage their commissions to pay for services.
-Michael Scotti
Crossing Nets: A Dark Playground for Algos and Blocks,” may have been the most anticipated panel of the day, given the number of new crossing systems in the marketplace. Interestingly, the launch of Level ATS was announced the morning of the conference. Equities crossing systems now number 33-and the 12 percent of buyside flow executed in these systems will continue to grow, according to Rob Hegarty, who heads securities and investments at TowerGroup. As these systems have multiplied, fragmentation-the inability to access disparate dark pools of liquidity-has became a major worry.
“We are deep in the fragmentation cycle, and we’ll be in consolidation mode in the next couple of years,” Hegarty said. Brokerage firms’ investment in crossing systems looks like a replay of their investment strategy with electronic communication systems in the late 1990s, which resulted in the roughly one dozen ECNs merging or being acquired. Hegarty expects that crossing networks will go down a similar consolidation path.
Liquidity will be the “defining factor” that determines whether a crossing network can survive, Hegarty said. For the ECNs, it was different. Technology made them successful, as well as access and speed.
Crossing Match Rates
Moderator Dave Leone, head of trading service strategies at BT Radianz, asked the panelists from crossing networks how they could increase match rates within their systems, estimated to be in the 3- to 6-percent range. The more open the systems are and the easier it is to access them, the higher the hit rates will go, panelists agreed. Many dark pools already can be reached by algorithms, and some of the systems are now connecting to each other.
Chris Heckman, a managing director at ITG, said orders have a higher hit rate when they move from dark pool to dark pool via technology, as opposed to staying in one execution venue. “It’s not as onerous as it once was,” Heckman said.
Alfred Berkeley III, chairman and CEO of Pipeline Trading Systems, said large orders left in his system for three hours increase their match rate dramatically, reaching 20 percent. “If you stay in the game, there’s a better chance someone will come to you,” Berkeley said.
Adam Nunes, vice president of strategy and product development at Nasdaq, said it makes sense the match rate would increase when information is sent to other participants that a contra-party exists for a trade, as in Pipeline. “But it depends how dark the dark pool is,” he said.
Liquidnet, the buyside-only matching system, has a match rate of about 30 percent, according to Steve Greenblatt, a vice president in corporate strategy at the firm. However, only a small portion of those matches actually trade because of the buyside’s constraints to pay for research and other brokerage services. About one-fifth of the 30 percent of the orders that match actually trade (6 percent total), according to previous reports in Traders Magazine.
Dark Pool Growth
So where’s crossing right now? Greg Tusar, head of electronic trading at Goldman Sachs, estimated that between 2 and 4 percent of the daily volume is executed in crossing networks. However, that represents about 15 percent of all the blocks executed in a day. As crossing networks become more sophisticated, Tusar said he could “easily” see them growing to 5 percent of daily volume and 20 to 25 percent of all block trades.
Regarding fragmentation, Tusar said algorithms and technology-namely smart routers-will remedy this current problem by sweeping dark pools. He also pointed out that algorithms have benefited investors by lowering transaction costs.
Liquidnet’s Greenblatt said that if algos are the answer to fragmentation, then the buyside needs to understand how their algos work. Otherwise, they “run the risk of sending signals to the market”-and that leakage could be used against them, he said.
On the future of dark pools, particularly the systems that aren’t owned by bulge bracket firms, ITG’s Heckman said, “We’re entering a phase where the bulge bracket firms will get more creative. They are coming to get us, and they’re in the game in a big way.”
In closing, Hegarty said crossing systems are in a race for their survival, and must be able to offer new functionality and garner liquidity. “If you don’t have an easy-to-evolve platform that is scalable, it’s going to be game over,’ ” he said. “You have to build a platform you can change.”
In an earlier panel, “The Block Trader’s Dilemma: The Risk Taker and His Tools,” industry execs said the fragmentation of the marketplace has led to an increase in their use of capital to execute clients’ trades. At the same time, the economics of block trading have changed. Brokers have seen their commissions squeezed, partly because of unbundling, and partly because clients are doing more trades themselves. Brokerage firms now look at how profitable a client is across product lines when they make decisions about executing blocks with their capital, panelists said.
Strategic vs. Tactical
Rob Arancio, co-head of U.S. liquid mar-
kets at Lehman Brothers, pointed out that there are two types of transactions clients seek: There are “strategic” transactions, which involve a mega-block that a client is looking to transact, and there are “tactical” trades, which involve the traditional use of capital to get, say, 100,000 shares on the tape to start off a larger order. (See related story in Industry Watch on page 22).
Moderator Chris Morstatt of TABB Group, asked about the current profitability of the capital commitment business.
Bob Harrington, head of U.S. cash trading at UBS Investment Bank, pointed out that going from 5 cents to 2.5 cents changed the economics of block trading. “The loss ratios are a lot higher now. If you look at any individual trade, most likely it is not going to be profitable. If you look at it in the context of the total relationship [with a client], we still think it is a service we are going to provide tactically.” The loss on the initial capital commitment in a name for one client is typically offset by the additional flow that follows from other clients, Harrington added.
Panelists talked about competition between their firms, with Lehman’s Arancio saying that clients who use capital almost always get a bid or offer. “It’s very tough with the number of [competitors] on tactical risk to say no’ [more than] once or twice out of every 100 times,” Arancio said. Ron Hammer, director of equity trading at Jefferies & Co., said the hope is that clients transact more business to offset a loss if the position desk takes a beating on an individual trade. “Some clients will offer more business because of the partnership, and others who will move on,” Hammer said. Arancio added that the demand for capital comes from the largest accounts. The smaller accounts don’t use capital. That’s because if a broker suffers a big loss, those accounts don’t have sufficient commissions to pay back the broker with more agency business.
Reg NMS Effect
With Regulation NMS and the NYSE’s hybrid on the horizon, panelists agreed that spreads will tighten in large-cap stocks. So if they are asked for capital in those names, they expect to be involved in even larger trades than they are now seeing. Also, none expect a change in how small- and mid-cap stocks will trade.
Regarding problems with the trade-through rule, Arancio said that technology-inter-market sweeps-should take care of that for the 20 percent of the block trades that get executed upstairs. “You might lose some of the print to the open market,” he said. “The job of the facilitator will be to help clients figure out price, and how we are going to fill in on the block that is broken up by fragmentation and [Reg NMS’s] requirement to fill top-of-book.”
Speakers on the buyside panel, “Does Size Matter?” agreed that it’s harder to find size today. A few years ago, the attitude was “block trading, no waiting,” said Mark Kuzminskas, director of equity trading at Robeco Investment Management. Now it’s “block trading, still waiting.” And instead of trading a block in one or two venues, it now often takes three to five venues to execute a large block, he said.
At the same time, Kuzminskas said he now sees many more block trades executing at a single so-called clearing price. Instead of a broker taking a portion of a block and working the rest, larger trades are getting executed, although further away from the current market price. “So there’s a bigger price concession that the buyside needs to make in exchange for these lower commission rates,” he said.
When Using Capital
Scott Haig, senior trader at State Street Global Advisors, agreed that there is value in the single-clearing-price model. His firm isn’t a big user of capital, but it does turn to the sellside when it wants to “offload the whole position in one shot.”
ING Investments had been a big user of capital, but is now more careful when it goes this route. “It’s more situational. We pick our spots,” said Michael Fenske, senior equity trader at ING Investments. He also said it’s important to get the bulk of large orders done at one time when using capital. “I have no interest in doing 25,000 shares when I have 500,000 to buy,” he said.
But while buyside interest in capital commitment remains strong for large blocks, the sellside’s attitude has tightened. Fenske pointed out that each sellside firms approaches the use of capital differently. Firms have become more selective in how they commit capital. It’s therefore useful to “proactively let your counterparties know what you’re looking for when it comes to capital,” he said.
Kuzminskas noted that some large brokers are increasingly tiering the information, services and liquidity they provide to buyside firms. This could make it harder for some shops to get blocks done.
Is sales trading a dying art? That was one of the many questions moderator Stuart George, head of equity trading at Delaware Investments, posed to four sales trading professionals: Steve Tullar, director of trading at JonesTrading; William Pauker, head of coverage sales at Credit Suisse; Greg Voetsch, head of Knight Capital Markets’ institutional client group; and Todd Trimmer, national sales manager at Weeden & Co.
Their answer was that the role is changing due to technology, but there is still tremendous value in finding the other side of the trade, particularly in small- and mid-cap stocks.
“You have your algos and you have your dark books,” said Knight’s Voetsch,”but the human element is going to continue to be huge.” Voetsch pointed out that just a few successful trades in less-liquid stocks could push a money manager’s performance into the next quartile.
Tullar of JonesTrading said that relationships are key in “digging out” the other side of the trade for less-liquid names.
Credit Suisse’s Pauker said that each account is different, and that whether a client demands electronic trading services or high-touch sales trading, a brokerage firm is responsible to understand how clients want to be serviced. “The role of the sales trader has clearly evolved and continues to evolve. He has to be better rounded and have a broader skill set,” Pauker said. “It’s part consultant, it’s part relationship management.”
Weeden’s Trimmer noted that his firm has had to adjust how it executes listed stocks as the markets have gone more electronic. Of its NYSE-listed business that does not get crossed against naturals upstairs, Trimmer said 70 percent is done electronically via DOT. The 30-percent balance is executed with floor brokers. That ratio used to be 50/50, he said. Weeden uses floor brokers only in small-cap situations, he added.
