What the market for dark liquidity pools needs is a little light.
So says Paul Hanson, a director at Alberta Market Solutions, a capital markets infrastructure specialist in Canada. The market for these huge anonymous block trades "should be open to anyone who's qualified. And by qualified, that means you have the money or the stock...I'm not concerned with the fact you're a hedge fund."
Hanson's volley was squarely aimed at members-only block trade firms like Liquidnet Holdings, whose software sits on the order management systems of buy-side clients allowing discreet and direct large-volume securities sales between fund managers.
Hanson says an alternative is needed and so his firm is helping to develop an alternative institutional trading system for six major brokerage investors that will go live online early next year. It will be called the Block Interest Discovery Service, or BIDS.
BIDS will be an open exchange crossing system where buyer postings and seller offers from institutions, brokers, hedge funds, mutual funds, pension funds and others can be automatically matched, or at least allowed to flirt within the tolerance of the bid-ask price, while remaining hidden from the market - the hallmark of an institutional block trade.
Its investors include Citigroup, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley and UBS; they are betting sell-siders can recapture some of the block trading market share they've lost in recent years to crossing trading systems. BIDS will be a come-one, come-all platform its organizers are betting can match or beat cost-per-share pricing models of current block trade firms. "The principles [investors] bought in on is that everybody should be allowed to play, and it should be open and industry-owned," Hanson says.
BIDS' arrival, along with another planned broker-owned system called Level ATS, heralds a new sell-side tactic against the masters of the dark side-the Liquidnets, the ITG POSITs and the Pipelines-as well as the major exchanges and electronic trading systems that have been increasingly wooing clients away from brokerages, and their commissions, for block trade activity.
Crossing networks are attractive to the large-volume trader because of the paradox inherent in trading huge chunks of shares: by placing an order, traders effectively announce their position and subsequently impact the price. Dropping a 200,000 share order into the quote system would be the "equivalent of dropping a boulder into a pond," as Liquidnet CEO and founder Seth Merrin explained in testimony he gave the Securities and Exchange Commission two years ago.
"Traditionally, that was actually resolved by you having a trusted broker who actually knew who held that stock," says Hanson. "This is why you picked different brokers for different trades." Utilizing Street brokers also presents the danger of leakage, where information of a trader's offer gets out and is subject to gaming by other brokers.
These issues, as well as the cost savings derived from crossing systems, has done much to spur an explosion of electronic trading formats in the past 18 months, and all but one firm, ITG, formed within the last five years.
Liquidnet, the market leader with a 37 percent share of ATS-based block trades, has earned a $2 billion valuation since its 2001 founding. ITG POSIT, the oldest of the firms, has built a daily trading volume of 35.1 million shares, on top of a 50 percent growth from Q4 2004 to Q4 2005. Both firms, as well as Pipeline, NyfixMillennium and the evolving electronic offerings from NYSE and Nasdaq, have been joined by plenty of crossing players. Rob Hegarty, managing director of TowerGroup's Securities & Investments Group, says 30-plus firms offer a crossing system. "A company just launched four years ago worth $2 billion [today] gets a lot of copycats," says Hegarty.
The rules for the systems may differ-Liquidnet caters only to buy-side firms, while Nyfix is exclusively for the sell-side-but the trading structure is similar across the board. Trades are executed when buyers and sellers input orders and offers, and matches are found through the algorithmic parameters in place.
A major downside to firewalled block trading is the low execution rate -TowerGroup earlier this year estimated only six of 100 block trades find a match in the crossing networks.
But when they go through, block crossing trades can drastically shave expenses. TowerGroup noted the average 4-5 cents for traditional institutional block trades can be more than cut in half with electronic matching (1-2 cents).
That price could be lowered even more when the brokerages enter the picture-perhaps commoditizing many of the ATSs out of business or into mergers. "Nasdaq is willing to do crossing for free for the first six months," says Sang Lee, managing partner for Aite Group. "I would venture to guess that BIDS will be very competitive in terms of pricing. Whatever these broker/dealers end up with, remember, it's not their core business."
Algorithmic trading technology and decimalization have contributed to dropping the average trade size from about 1,400 in 1998 to between 200 and 300, says Hegarty. But the average daily volume for the top four crossing networks has grown to 98 million shares. Hanson says BIDS is "a fundamentally different kind of play. We're not an investor-backed, for-profit business trying to create a whopping big valuation for investors. We're really here to create a market structure that's suitable and appropriate and efficient. There haven't been 33 like that."
One thing going for BIDS "is they already have liquidity in their platform," adds Lee. "It's a lot easier to have a defensive posture when you have liquidity already. "The question is, can they hold on to it?"
At launch, BIDS will be integrated into the order management systems of the major broker investors, and will either auto-match trades or set up direct contact for negotiations between traders. An eBay-style profiling system will alert a firm to a prospective partner's buying (or deal-breaking) history.
One of the unknowns headed into next year for BIDS and other crossing systems may be the SEC's interest in looking into the transparency issues of "dark pools," as well as implementation of RegNMS, the upcoming SEC regulation for trade-through and best-price rules.
