The handling of large blocks of stock by human traders, written off as a dying art in this age of algorithms, may be making a comeback. Bulge-bracket shops appear more inclined to put their capital on the line to win back the higher margin block business and buyside desks have their own agendas. Wall Street's biggest firms want more of that institutional flow, and are willing to use more of their capital to get it. This strategy has coincided with an uptick in block trading over the last six months, traders anecdotally report. "The pendulum is swinging back to block trading," says David Briggs, global head of equity trading at Federated Investors. "We've driven down the costs of trading, and now we have to figure out how to capture alpha."
Another buysider noted: "Brokers are using capital to differentiate themselves. The block business is making a comeback."
The block business began to take a hit in 2001 when the New York Stock Exchange and Nasdaq required all trades be done in penny increments. Displayed liquidity subsequently dried up, practically forcing the sellside to feed its customers' orders into the market in piecemeal fashion with the use of computerized trading algorithms. Demand for old-fashioned human order handling plunged.
The Numbers
Data from the New York and Nasdaq illustrate the changes. In 2001, 48 percent of all volume traded on the Big Board was in blocks of 10,000 shares or more. Last December, only 27 percent was.
Protecting anonymity and avoiding market impact have been the key drivers in order routing practices in a low-volatility, low-return environment in recent years. Block trading was getting nudged to the side.
The buyside paradox-I want to see your size, but you can't see mine-helped to exacerbate the drop in block trading at a time when money managers-under pressure from mutual fund boards and institutional investors-were slashing commissions as their trading volumes were themselves plummeting. Brokers axed traders in the new economic reality of institutional trading, and gave the buyside the electronic trading tools that they had been using. The result: a rise in the use of direct market access and algorithms, which take big orders and make them look like retail orders.
"The SEC set up a market for retail-sized trades and then was surprised that all they got were retail-sized trades," commented one observer.
The growing popularity of trade-cost analysis has also handcuffed the buyside from making trading decisions that involve capital, said one head trader at a mutual fund. It might actually be better to pay up for stock and get a block done immediately, rather than whack away at a few hundred shares at a clip in an algorithm. The problem is that the scrutiny of mutual fund boards is hampering decision-making, particularly if the trade wasn't a good one in retrospect.
The tide may be turning, however. The rise in the number of big blocks traded after the close-spot secondaries-is a daily occurrence. Also, anecdotal evidence suggests money managers are reconsidering the sellside's block desk.
Best Clients
A handful of brokerage execs confirmed their increased willingness to commit capital, including three of the biggest firms on Wall Street. But that capital is only available to their best clients-those who generate enough commissions that a loss from a principal trade will not clobber a broker's P&L with an account.
One head trader on the buyside who sees an increase in block activity said his brokers are looking to get more involved in his account. He said one brokerage firm suggested it would like to see its loss ratio with the client double, to about 18 percent. That would mean if this account did $10 million in commissions, that broker would be willing to swallow $1.8 million in losses from committing capital. That's the carrot that brokerage firms are dangling in front of their best clients: Do more business and we'll take the losses from the tough trades. In the end, the brokers are looking to increase their bottom lines. So, even with higher loss ratios, clients will hopefully be more profitable with the additional business.
This head trader likened developments in the block business to the program trading game, where brokers make tight bids in order to get the flow and curry favor with clients. "It's a cyclical thing," the buysider said.
(Capital isn't for everyone, of course. Institutional clients don't like to be tied to an order with a broker and then see natural flow trade away. Nor are they crazy about the market impact that sometimes follows a block trade.)
Capital Numbers
Consultancy Greenwich Associates reports that 14 percent of all institutional volume required a capital commitment in 2005, while that figure is expected fall to 12 percent in 2006.
Bulge-bracket firms aren't just pushing capital to compete with each other. They are also competing against the upstart crossing networks and algorithms. More and more of the institutional flow, that used to run through upstairs trading desks, is now going right to market via DMA products. Large institutional orders that sit anonymously in various dark pools are growing.
"We are trying to get the buyside out of these crossing networks," said an executive at a bulge-bracket firm. "We need to make outsized liquidity, and it's challenging."
The renewed interest in capital commitment comes as many on both the buyside and the sellside say they are frustrated by their inability to trade in size. The recent growth of fragmentation from orders hidden in dark pools of liquidity-crossing networks-is one reason for the frustration. The list of these nets' is plentiful and growing, as well as the liquidity beginning to go into them. The list includes ITG's Posit, NYFIX Millenium, and Pipeline. The big brokers are even developing their own.
"There is a real anxiety or concern about getting liquidity," said Todd Sandoz, head of cash trading at Credit Suisse, "and that's been one of the downsides of the electronic marketplace. If you really do have a large size block, a lot of times those venues don't meet that demand."
Natural Attraction
Money managers have always wanted to trade in block size, particularly if it's natural flow-a counterparty from the buyside with contra-side interest. Many point to the success of Liquidnet-a private network that allows money managers to trade blocks with each other. That's proof that that size still matters to institutions, they say. Liquidnet's anonymity and its natural flow have been two key factors in its popularity. It's essentially a safe house for institutional trading. Wayne Wagner, who founded Plexus Group, a trade-cost analysis consultant, explained why institutions value anonymity as much as they do: "The sharks out there in the marketplace vastly outnumber the fish." Wagner pointed out that about 70 percent of all orders at firms using Plexus are over 50,000 shares.
One firm looking to capitalize on clients' desire for natural size-Credit Suisse-has rolled out what it believes is an advanced indication-of-interest product that will only shop natural flow (See sidebar).
The Comeback
Besides Liquidnet's success, several recent developments may have whet the appetites of institutions to trade in size once again, sources said. Some say that buyside traders now have a better understanding of how to trade in an electronic marketplace and still search for size. For other buysiders, some say, it is a reaction against algorithms and a way to take control of the order again by getting back to their roots of block trading, a skill in which they can add value. In the meantime, assets continue to grow and the buyside needs greater and greater access to liquidity.
"Clients are looking for that liquidity opportunity," said Barry Small, chief executive at Weeden & Co. "They're saying, we want to get something to the tape, to bring out the other players.' We're committing more capital in the tough names, the small- and mid-caps."
New Attitude
That may be a change. The retreat by the buyside from trading in blocks may be at an end.
"There seems to be a greater willingness by money managers to trade in blocks," said Tom Wright, global equity head of trading at Sanford C. Bernstein, who agreed that block trading has increased.
So what's the evidence?
Another sellsider attributed part of this to clients opening up more and discussing strategies as they try to place large trades in a fragmented market.
Also, there's been a move away from value-weighted average price (VWAP) as a benchmark for buyside traders, and a movement toward an arrival-price model at the money management firms. That strategy measures a trader's performance from the time he receives the order until the time the trade is completed.
VWAP measures a trade's results against the average of everyone else's results.
Fidelity Investments, which led the charge that made VWAP the standard strategy in recent years, has backed away from that benchmark, sources report. It now favors an arrival-price strategy, which gives traders more leeway in making decisions to access liquidity, sources said.
Briggs, at Federated, pointed out that buyside traders concentrate on adding value on about 20 percent of the stocks they trade.
Block trading has been a "core piece of our business that is important and has been ignored," Briggs added. "There is only one way to add to performance and that is by making trading decisions."
Sellside Improvement
On the sellside, position traders are much better at analyzing risk these days, sources say. Now that less liquidity is displayed in the markets, position traders have had to get the hang of analytics and other market keys to judge their risk better. And, interestingly, despite less flow hitting their desks, these traders have actually improved at positioning the difficult trades, said one position trader at a bulge-bracket firm. That's because they no longer have to deal with the maintenance-type orders and are more focused on their sectors, he said.
Scott Jones, director of global equity trading at Jefferies & Co., agreed with that assessment. "The information flow is so much better and faster with sector trading, I think traders are more comfortable pricing merchandise."
Still, one head trader at a global money management firm estimated that the cost of capital-which is reflected in the upstairs spread-is up about 5 percent from last year. Another source said he has seen a widening of the spread offered for small- and mid-cap stocks. While a couple of years ago, a buysider said he used to expect a quote 2 or 3 cents off the NBBO, he now expects to see wider pricing, say, a dime off the bid or offer. One large institution suggested that since brokers no longer get the easier trades to offset their riskier ones, spreads had to widen in order to compensate for that lost business.
One change that has impacted trading in size has been the reorganization of brokerage desks. As volume and commissions shrank in recent years, brokerage firms reacted by downsizing. As brokers shed the experienced and higher-priced sales traders, the relationships and trust that they culled with their clients over the years went out the window. Brokers also began tiering their accounts to ration services to their best clients.
Sales traders take years to develop strong relationships and they're judged by their performance over time, suggested one buyside trader.
Buyside Shuffle
The money managers paying the highest commissions, for the most part, have been able to keep the same coverage. But much of the buyside's coverage experienced a reshuffling. It's hard to share sensitive trading information and open up to a stranger.
One source suggested that this restructuring of coverage further hastened the flow of information and orders to the traditional sales trading desk. Recently, this buysider was trading a high-priced and volatile large-cap stock. The broker was new-a research boutique-as was the coverage.
Consequently, the buysider was parceling out the order in 10,000-share lots. The sales trader announced that he had to leave the office early and his backup would continue working the order. The good news was that the backup had intermittently covered this buysider for more than 20 years: They had a relationship. "I opened up and gave him my entire picture of 600,000 shares to work, and he did a good job," the trader said.
Michael Hornbuckle, president of Jones Trading, a third-market firm, agreed that familiarity bred openness. "If there is a relationship and a level of trust, then you can get that information to trade the bigger blocks," Hornbuckle said. "If you want to do the big trades, you've got to have the human touch involved."
Greg Cavallo, who heads trading at agency broker LaBranche Financial Services, pointed out that "there's a whole conversation of color and flavor that takes place on the phone that doesn't happen in a black box."
How the block business evolves with the advent of dark pools and Reg NMS is anyone's guess, but for now, brokers are willing to step up to the plate and offer their capital to stay in the game.
"We think that as market structure continues to evolve," said Credit Suisse's Sandoz, "there is going to be a real demand for providing liquidity, and that means getting back to the block business."
