With the coming of the Chicago Stock Exchange's ChicagoMatch and the development of such systems as the Arizona Stock Exchange and CS First Boston Group Inc.'s Lattice Trading Inc., non-traditional trading systems have moved far beyond their initial goal of providing low-cost "informationless" trades.
The most widely used off-exchange trading systems are the pioneers - Investment Technology Group Inc.'s POSIT and Reuters Holdings PLC's Instinet Crossing Network.
But the newer entrants, along with Instinet's regular day system, are giving investors a growing number of choices in trading equities.
Among institutional investors, TIAA-CREF, the $124 billion defined contribution fund, trades 75% of its $3 billion internally run quantitative equity portfolio on the alternative systems, said Jonathan Shane, investment systems officer for the Teachers Insurance & Annuity Association-College Retirement Equities Fund, New York.
Vantage Global Advisors, New York, which manages $2.5 billion in assets, virtually all for tax-exempt clients, now does roughly 20% of its trading through the alternative electronic systems, said T. Scott Williams, senior vice president.
The Marshall Plan, Crystal Bay, Nev., and Boston, which runs $58 million, virtually all from tax-exempt clients, does at least half of its trading through the crossing and other non-traditional systems, said Greta E. Marshall, chief investment officer.
Aronson + Fogler, Philadelphia, which runs $800 million for tax-exempt clients in quantitative styles, uses the alternative systems for 65% of its trades.
"They now dominate our trading," said Theodore R. Aronson, its chief investment officer.
"We were on the networks from the first day," he added, mentioning POSIT ( which stands for Portfolio System for Institutional Trading), the Crossing Network, and the Arizona exchange.
Together, the alternative systems trade about 10% of the volume of the New York Stock Exchange. That volume is proof of the increasing demand by institutional investors for alternative trading methods to the traditional stock exchanges or National Association of Security Dealers' NASDAQ markets, according to officials of the non-traditional systems.
"The Big Board is clearly losing volume," said Mr. Aronson. "But it's not tremendous."
To counter the non-traditional systems, the NYSE began an after-hours trading session. But it isn't widely used. One reason is traders have to use a broker, compromising, among other things, investors' anonymity.
"The vast bulk of everything we do in trading is very different from what we were doing 20 years ago," or even a few years ago, said Wayne H. Wagner, partner with Plexus Group, Santa Monica, Calif., which evaluates trading for institutions.
The new systems' most powerful features give institutional investors control over their trades and allow them to spend more time on decision analysis to develop better trading strategies and evaluations.
Speaking about Boston-based Lattice, Evan Schulman, its president, said the computer, or the electronic, trading, takes care of the work of carrying out trades according to the rules or constraints the investor has designed.
"The trader can spend his time thinking about how he wants to do a trade," instead of relaying instructions to a broker. "Rather than being a clerk, a trader can be a thinker."
Mr. Schulman's comments apply to the other non-traditional trading systems as well.
"The control of trading is moving managers and pension sponsors away from brokers," Mr. Wagner said.
Institutions under pressure
Institutions are being driven to improve their trading by the increasing competitiveness of money management, where any fraction of a point gained from better trading compounds into a meaningful performance advantage.
"Investors are facing ... pressures to improve performance," notes a study prepared by Booz Allen & Hamilton Inc., New York.
"They are increasingly focusing on expense management and ways to decrease transaction costs, not only commission rates but also market impact costs."
At the same time, the Department of Labor, through the Employee Retirement Income Security Act, is "putting pressure on pension funds to comply with their fiduciary responsibility of ensuring that investment managers achieve 'best execution.'"
"The money management business has gotten more competitive," added Davis Gaynes, senior vice president-sales and marketing, Instinet Corp., New York. Money managers "realize an eighth of a point does matter, even if they plan to hold the stock a long time."
With its QuantEX, Investment Technology Group, which also runs POSIT, offers a similar integrating trading system, including rule-setting trading.
Good money management has two components, Mr. Wagner said. One is portfolio decision-making, deciding what equities to buy and sell. The other is portfolio operations, deciding how to buy and sell.
"Not capturing the value of ideas wastes performance," he added.
Many still argue that because performance reflects transaction costs, why not focus only on the big, overall number. Mr. Wagner answers: "Because you can do something about" trading costs. An investor can improve trading to reduce costs and thus improve performance, he notes.
Not just minimizing commissions
Growing recognition that best execution is more than just minimizing commissions spurred the development of the non-traditional systems.
The systems reduce the impact of execution. In the cases of POSIT, the Crossing Network and the crossing features of the Arizona Stock Exchange and the pending ChicagoMatch, they eliminate any execution impact by trading stocks at the quoted prices at specific times of the day.
The new systems change the way orders are sent - electronically over computer networks, rather than communicating with brokers. As Mr. Schulman indicated, the computer will work the order, following certain rules or constraints - or as he calls it, an algorithm - that could change automatically with changing events in the markets or with an investors' own portfolio.
Speaking of Lattice, he said, "We give traders tools so they can condition their trades on certain events."
Roger Hendrick, vice president-institutional market at the Chicago Stock Exchange, sponsor of the new ChicagoMatch, calls this kind of trading "success-counts parameters."
As Lattice does now, ChicagoMatch will enable investors to place constraints on their trades, all in a computer transmission.
"This is particularly useful for long-short strategies or paired strategies," Mr. Hendrick said. "For example, I'll only buy Ford if I can sell GM."
At Instinet, Mr. Gaynes calls the attaching of rules to electronic trades "order management."
Just as importantly, the systems interface with a money manager's own computerized accounting system, allowing trades to be automatically recorded and split into the accounts of different clients.
"Internally we classify all trading into two broad categories," said Aronson + Fogler's Mr. Aronson.
"Traditional is on the telephone, yelling and screaming, buying and selling. Non-traditional is crossing," on POSIT, Instinet's crossing network or the Arizona exchange.
Liquidity is the key to all of the systems.
"Crossing networks is a game of critical mass," said Matt Yamini, vice president-equity trader at Provident Investment Counsel, Pasadena, Calif., speaking at a conference of the Association of Investment Management and Research.
In terms of "critical mass," the systems haven't reached the volume yet to accommodate all crosses for all stocks every day.
Lower trading costs will make more ideas actionable, increasing trading volume and providing the greater liquidity traders want, Plexus' Mr. Wagner said. Fewer strategies will be constrained by the impact of the cost of trading on their ultimate profitability.
"If you build it big enough, people will come," said Randy MacDonald, chief financial officer at ITG, which operates POSIT.
ChicagoMatch may be potent
The Chicago Stock Exchange's ChicagoMatch is the newest and potentially most potent alternative system. Its start, once expected in July, has been delayed until at least September, awaiting Securities and Exchange Commission approval, according to Mr. Hendrick.
So far, ChicagoMatch has been installed at some 60 institutional investors, including the California Public Employees' Retirement System, TIAA-CREF and GTE Corp.'s pension fund. Other institutions with the system include Allstate Insurance Group, Fidelity Management & Research Co., Vanguard Group, Aronson + Fogler, and Vantage.
The Chicago exchange expects to add another 25 investors before ChicagoMatch starts.
The system, designed to operate on existing Windows-based personal computers, takes up no additional space on institutional traders' desks.
"The principal reason for using ChicagoMatch is to avoid market impact," said Mr. Hendrick.
ChicagoMatch offers similar elemental features of the crossing systems and adds some features to broaden its appeal and its goal of getting trades done.
"I think it's a real sexy idea," said Mr. Aronson.
As planned on ChicagoMatch, simple crosses - trades matching buy and sell orders at the quoted prices on the traditional exchanges - will give both parties anonymity and cost 2 cents a share.
But ChicagoMatch will charge only a half-cent a share for those who disclose their identity in recognition of its value to the trading community.
To encourage more aggressive trading, the system will allow investors to motivate, or as the executives as the systems say, "incentivize" trading. That is, premiums or discounts of 1, 2 or more cents per share above or below the midpoint of the bid-and-ask spread will be offered. But the incentives must stay within the bid-ask spread, typically one-eighth point, Mr. Hendrick said.
"The premium puts you to the front of the line," said Edward C. Story, an independent consultant working on ChicagoMatch. "It's a queuing mechanism. The higher the premium you offer, the more likely you will get the liquidity that you need."
Other simple crossing systems offer no priority to investors.
"We are encouraging market-makers to participate" to improve liquidity, said Mr. Story. "You have to get active management involvement in a crossing network to give it liquidity," he added. The ChicagoMatch premium "is designed for the active management community."
ChicagoMatch also will allow investors to sell short on a down tick, or decline on stock price. NYSE rules allow short-sell trades only on an up tick to prevent a continuing slide in a price.
But Mr. Hendrick said ChicagoMatch has asked the SEC for an exception to the rule, "because the price used by the system" - which is the quoted price on the exchange - "is independent of the person trading." So it avoids the bad effects of trading on a down tick, he added.
Initially, trading will occur at the midday price of the exchanges, until demands call for additional times for matches.
In addition, ChicagoMatch will report "near matches," or trades that come close to crossing.
If investors want, the system will report to them such near matches and bring them together with a mutually acceptable broker to negotiate the trade. These trades will move outside ChicagoMatch to the traditional trading realm with its normal commissions. But presumably because of the near match, it will achieve better execution for both parties.
Soft-dollar trades available
The new systems even accommodate higher commissioned soft-dollar trades. ChicagoMatch, like Instinet, POSIT and other systems, provides for soft-dollar, or directed brokerage, trading. Traders simply added 1, 2 or more cents a share to the trading fee the systems charge, directing the additional amounts to go to certain brokers to pay for services.
"Soft dollars usually implies some compromise of execution," said Instinet's Mr. Gaynes. But with the non-traditional systems like Instinet, investors can manage the execution better than by allowing a soft-dollar broker to work a trade.
With innovations to traditional crossings, the non-traditional systems are trying to appeal to more active portfolio managers.
Quantitative managers initially were attracted. "They use computers to pick stocks," said Plexus' Mr. Wagner. "So why wouldn't they use computers to trade stocks?" Unlike a lot of active managers, he added, "they are predisposed to use computers."
For active managers that's changing, but maybe now only somewhat.
"Important messages come through for active portfolio managers in trading," Mr. Wagner said.
"Research tells them what they know about a stock. But research doesn't tell them what others think about the stock. Trading gives them that kind of information."
The non-traditional systems "aren't about to replace the NYSE or dealer markets," Mr. Wagner said. "They have natural limits" on their appeal. "But I don't know where they are."
"There are different buy-side and sell-side needs and wants in trading," he added. "Not everybody needs the type of trading on the exchanges." That has led to the growth of the non-traditional systems.
"There is a mindset that crossing networks are populated by passive and quant managers," said Mr. Story.
"Marketing a crossing network, we couldn't get it to critical mass unless we have active manager participation."
Investors control trades
A major appeal of the new systems is they enable investors to control their trades.
Like other systems, current daily volume isn't disclosed. POSIT, the biggest crossing system, averaged 8.3 million shares a day in the last quarter of 1993, its latest available data, according to ITG's Mr. MacDonald. POSIT trades four times a day, all during market hours, using the prices at those times.
Running several times a day, POSIT "gives you a better chance to do more trading," said Vantage's Mr. Williams, which might account for its leading volume of the crossing systems. The Crossing Network and the Arizona exchange run once a day, as will the ChicagoMatch. But other systems, like Lattice, offer what their executives call "continuous crosses," meaning they trade all day.
In terms of oversees, Instinet already trades some foreign stocks, while POSIT is in the process of building a global trading system in London along its U.S. line. The other two main alternative systems, the Crossing Network and the Arizona exchange have no overseas trading.
"Europeans are catching up to the U.S.," POSIT's Mr. MacDonald said. "They've never paid attention to transaction costs" like U.S. investors.
Its European business is small now. "We have a one-man shop that's inadequate." But he said POSIT is in the process of adding staff abroad. "We plan to go after that business very aggressively."
Even though the Arizona exchange was set up to take trading beyond simply crossing stock orders at the market price, through an auction system allowing for price discover, 90% of the trading is crossing, taking place at the market price. The Arizona exchange, which began in 1992, trades once a day, after the market close.
Volume is now about 400,000 shares a day, according to Steve Wunsch, president of AZX Inc., which owns the exchange.
Some 140 institutions have installations.
Plexus' Mr. Wagner calls the Arizona auction system difficult to use for investors that want to trade a basket of stocks, which explains in part why its crossing feature is used more often. It's hard to keep track of the auctions that would involve many different stocks, he said.
Instinet, whose executives call it an electronic broker, has two systems.
Its so-called day system, started in 1969, interactively allows buyers and sellers to negotiate trades anonymously by placing their bids through computers. It's primarily used to trade over-the-counter stocks, according to investors interviewed, because they trade at lower spreads, often at the midpoint of the bid-ask spread, to avoid the more costly trading through NASD market-makers.
"We find that very useful," said Vantage's Mr. Williams. NASD dealers often refuse to reduce the spread to maintain their profit margin, he added.
"Hardly anybody uses Instinet for NYSE trading," Mr. Aronson said. "Everybody uses it to trade OTC stocks."
Its Crossing Network, started in 1986, operates at the close of the market, anonymously crossing trades at the closing price and charging a 1-cent commission.
Lattice was developed by Mr. Schulman, who had developed the unrelated system used by Batterymarch Financial Management, Boston.
TIAA-CREF, among a small number of other institutions, has used Lattice, said the pension fund's Mr. Shane.
"We behave just like a broker, only a little faster," said Mr. Schulman, who calls Lattice "an electronic execution engine."
Started 11/2 years ago, Lattice has a daily volume in the mid-six figure range, Mr. Schulman said.
Lattice will cross trades at the market price, or send them through the floor through brokers.
Lattice is designed to "find the best price, whether its on Lattice or routed to the exchange," Mr. Schulman said.
"We designed our system to appeal to both passive and active investors."
Morgan Stanley & Co., New York, has a similar system it calls MatchPlus, which began in 1991. Like the other alternative systems, it offers anonymity and like Lattice offers continuous trading throughout the time the NYSE is operating. It will match trades, or route trades to other markets to fill orders.