Block Trading:

2008 Is Set to Be a Pivotal Year for Innovative Technologies to Support Trading of Large Blocks

Originally published January 21, 2008

NEW YORK — As NYSE Euronext joins with BIDS Trading to enter the US block trading venue competition, established alternative block trading venues such as Liquidnet, Pipeline and BLOCKalert are looking to strengthen their global reach and better cater to buy-side users.

“To be a true block offering to the buy side, we have to recognize how the buy side is investing,” says Alfred Eskandar, Director of Corporate Strategy at Liquidnet Inc. “It’s investing not just in the US — there are far too many opportunities overseas they need to get into and they need a vehicle, a marketplace to transact those ideas at large size. At this point, we trade 24 different markets.”

NYSE Euronext’s venture with BIDS represents a change in market structure, observes Tim O’Connell, Senior Manager in the Capital Markets Group at consultancy BearingPoint Inc. “This is an exchange that’s actually partnering with one of these OTC block-trading venues,” he says. “That’s a definite shift from where they were, which was all exchange-based trading. So now they’re legitimizing an off-exchange venue for the purpose of matching blocks. That validation by NYSE Euronext is a lot of credibility for BIDS.” In fact, NYSE Euronext is breaking its own rules in market structure, he adds.

NYSE Euronext benefits from BIDS reporting trades through its systems, which means it gets back trade volume it had lost, notes O’Connell. “NYSE also gets an alternative venue to show liquidity to its members,” he says. “BIDS gets investment and branding that’s definitely valuable, and may also get a share of market data from NYSE Euronext for trades that BIDS prints.”

 However, in the competition for block order flow, not all venues are the same, observes Eskandar. “Broker-sponsored models such as [Goldman Sachs’] SIGMA X and [Credit Suisse’s] CrossFinder are well-positioned to grow,” he says.

“They serve both as internalization engines for their respective firms and also have the liquidity and financial and technological support of those giant banks to continue operating. Then there’s a host of new upstarts that have an even-greater challenge. They don’t have the financial backing or the technology or the liquidity. So they start from a very difficult point.”

Exchanges fear competition from large broker-dealers internalizing order flow, and from firms like BIDS, observes O’Connell. Independent broker-sponsored models are the most competitive, according to O’Connell, who points to offerings from Bank of America, Citi, Bear Stearns, Credit Suisse, Deutsche Bank and Goldman Sachs, all of whom are also investors in BIDS.

“Those represent a significant amount of volume,” he says. “They’re not trying to make BIDS a for-profit entity at the moment. They are more interested in making it a utility to serve their needs, so they’re making money in a different way. The only thing that really competes with block trading and this kind of matching is commitment of capital by dealers willing to take on a block like that. But large buy-side participants who want to move a large number of shares don’t get the anonymity they’re looking for.”

The use of algorithms is also affecting the operation of block trading venues and the block marketplace, according to Eskandar. “A lot of the order flow that used to be written on a block trader or position trader notepad, where you couldn’t interact with it, is now being fed into algorithmic engines,” he says. “A lot of the fragmented flow is becoming electronic. The problem is the institutions are also having their orders sprayed. The whole notion of trying to be in all places at once isn’t the best solution for a large block trade.”

BLOCKalert, which began as a venture of ITG Inc., is now a partnership between Merrill Lynch and ITG. “What makes us unique is that we’re a multi-broker platform,” says Steven J. Sorice, Chief Executive Officer, BLOCKalert. “When this was strictly an ITG product, it was one of many products that clients paid ITG for. With a firm like Merrill Lynch that provides capital and research, clients have lots of different reasons to use it.”

Buy-side firms need help in trading blocks of less liquid names, explains Christine Sandler, Head of Sales at BLOCKalert. “Buy-side clients say they don’t need help trading Cisco, but rather trading the stock that takes 30 days to liquidate a position or when there’s seven days of volume to move,” he says. “This is what they need solved. Clients can source two forms of liquidity – peer-level liquidity in the form of indications and also standing order flow that alerts them, where anonymity and lack of information leakage are really huge factors.”

BLOCKalert seeks to differentiate itself by offering a standing pool of liquidity, explains Sorice. “Those orders aren’t in lots of other places other than our network,” he says. “They’re unique to the portfolio process that occurs in POSIT [ITG’s trade matching and crossing system, which powers BLOCKalert]. That unique liquidity is attractive to the buy side when it’s trying to source liquidity.”

 The future for BLOCKalert, Pipeline and Liquidnet is to improve upon the filtering tools they offer, according to O’Connell of BearingPoint. “Liquidnet already does a great job serving buy-side customers. Pipeline and BLOCKalert understand what features they’re looking for,” he says. “Some of it is being able to put in profiling tools that allow you to filter through the garbage in these crossing networks and find out what is legitimate and real liquidity. To the extent they can keep building these tools out and make them more attractive to the buy side, they can expand their buy-side volume.”

 With multiple block trading venues competing, fragmentation is always a danger, observes O’Connell. “To the extent firms can start concentrating partnerships in some of the block trading venues, they can re-aggregate the flow,” he says. “There are now opportunities to create larger size from multiple trades that might happen elsewhere, to the extent there are better opportunities to match them at some of these block trading venues. Firms would much rather move a block than have to do an enormous number of trades using algorithms, and then process all of them.”

The block trading venues will also have to watch out for the effects of MiFID in Europe, according to Benn Steil, Senior Fellow and Director of International Economics at the Council on Foreign Relations and Director at consultancy Efficient Frontiers LLC. “MiFID is potentially a threat to systems like Liquidnet, which has no pre-trade transparency in it,” he says. “Liquidnet’s prices and quotations aren’t published out to the market. To the extent that Liquidnet is a success, it’s a success because there’s no pre-trade transparency in it.”

The use of algorithms in block trading is pushing the number of trades up even as the number of personnel firms employ to process the trades is cut, according to Dushyant Shahrawat, Senior Analyst in the Securities and Investments Practice at consultancy TowerGroup. “Over the past six years, trading volume has risen 191 percent,” he says.

“The only way for a securities firm to manage that is to automate a large part of its trading process. That puts tremendous strain on the financial and securities firms operating in this business, whether they’re broker-dealers, investment management firms, hedge funds, custodian banks or any of the other entities that serve this market.

“While the total trade volume has been growing, the same block trades are being split into smaller pieces,” adds Shahrawat. “That means the number of small orders is growing pretty dramatically over time. The more transactions that are done, the greater the impact is on the entire technology infrastructure that supports this market.”

Another possibility block trading venues could consider is adding trading features that would set rules around participation in the market that are similar to the systems used on eBay or Amazon Marketplace for buyers and sellers of used items or collectibles, to evaluate the counterparties in their transactions, according to O’Connell. This would serve as an additional feature beyond just a venue’s ability to reach liquidity and facilitate block trades. “They may track statistics of how often when a market participant starts a negotiation, they actually finish it,” he says. “I may put in limits that I will only participate in a trade with counterparties that complete 75 percent or more of their negotiations with some kind of trade. That weeds out the ‘fly-by-nights.’ That kind of feature would attract participants as well.”

If 2007 is remembered as the year that NYSE Euronext sought to recapture the block trading flow it lost to various competing venues, 2008 could be either the year when NYSE Euronext achieves this or competitive forums successful stave off a NYSE Euronext comeback in block trading.        


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