Sold to You Under the Buttonwood Tree

The alpha trader of old often transacted on behalf of an institutional client by tapping his network–Sold to you was the verbal handshake that got a large trade done in a few phone calls. The high-frequency trader changed the game from one of relationships to a technological arms race. Evading, slowing down, ex-communicating or simply accepting the speed demons as benign has produced mixed results in a hyper competitive market. But, a properly functioning market has cooperative as well as competitive elements. Auction markets have both: a set of rules that level the playing field for investors interested in getting the best price, not gaming the system. I propose that we use technology to better establish auction markets, which is to say, rebuild relationships among institutional investors in an online forum.

The facts support the effectiveness of auction markets. A significant volume of daily trading is conducted during the opening and closing auctions on many exchanges, especially for small cap stocks. The New York Stock Exchange publishes indicative price and volume information with increasing frequency as the market open approaches and again near the close. Traders use this information to determine their participation. It is an orderly process in which speed is not a factor-the market clearing price is the price at which the greatest share volume is executed.

Some exchanges have recently adopted midday auctions, briefly pausing continuous trading, while others have opted for periodic or on-demand auctions held alongside continuous trading. Time will tell if on-exchange intraday auctions will be a wholly satisfying solution for institutional investors, given that exchanges have other constituencies to please. I have my doubts.

Meanwhile, off-exchange auctions have been resurrected by some institutional investors, such as Norways sovereign wealth fund which is increasingly turning to a trusted network of asset managers and brokers to move large share blocks. This upstairs market can provide more efficient execution than algorithms that chop a block into easily digestible pieces executed on numerous exchanges, sometimes over several days. The longer it takes to execute a trade, the higher the risk of adverse price movements; the more venues that are used, the more detectible the footprint.

Some dark pools mimic the auction process by enabling counterparties to negotiate price and share volume electronically. However, the opaqueness of dark pools impedes price discovery-since participants do not know the potential volume to be traded, they are skittish about committing to a trade when they find an interested party.

Auctions solve a key problem of continuous markets where counterparties are not present at the same time. Spreading a large order over the course of the day only exacerbates market impact when trading in a security is concentrated at the beginning and end of day. In an auction, traders come together at a specific point in time, thereby mitigating the supply-demand imbalances that often occur in continuous markets. To encourage participation, an auctioneer must provide traders the assurance that all participants will commit to trade at the market clearing price, rather than walk away with competitive information. For instance, the inability to cancel orders during the few minutes prior and after the market open on the New York Stock Exchange serves this purpose.

Further, an auction will work best if the alpha trader is put back in control. On-demand auctions with select counterparties-those most likely to have an interest in the security to be traded-focus minds on getting the trade done. If you are chosen and do not attend, its highly probable that others will take your trade.

The auctioneer can provide a valuable service by using technology to source the most desirable counterparties. These may include HFTs who act as market makers, as long as the auctioneer can prevent predatory practices. Institutional investors who are suspicious of liquidity providers, HFTs or those by any other name, need not invite them-they can simply transact with other institutional investors, however much this limits available liquidity. The choice is theirs. The institutional investor is assured that the auctioneer himself, acting only as agent, will not profit from any information obtained by virtue of his office.

Whereas in other areas, technology is used to create online communities of interested parties, in trading it is often used to obfuscate and evade detection. An off-exchange auction market is more necessary for illiquid securities, such as small cap stocks and corporate bonds. The technology exists and has been deployed by a few private marketplaces. Its time to rebuild relationships in an online forum for the benefit of long term investors.