Electronic systems’ popularity hits block desks hard

Use of block trading desks, like sell-side trading desks in general, will shrink by as much as 50% as institutional asset managers — including hedge funds — continue to use electronic trading systems for more efficient trading and less information leakage.

Before decimalization in 2001, when stock prices were quoted in eighths of a dollar instead of pennies, and before the widespread use of electronic trading methods, block-trading desks handled up to 70% of daily stock market volume, according to some estimates.

"You'll get a debate about whether it was 50% or 70%, but I'm of the opinion it's going to be cut in half, and cut in half quickly," said Richard A. Kos, founder of Kos Consulting Group, Madison, Conn., an investment consulting firm.

"Block trading was the option of choice for large, institutional buy-side traders but it's being eclipsed by the algorithm and program trading world," he said. "I've never seen it as under siege as it is now."

On the New York Stock Exchange, which defines a block as a trade of 10,000 shares or more, block trading on a monthly basis is around 30% of trading volume. Trading experts said that number understates total block volume because of how it is measured and the fact that some block volume does not cross the Big Board.

Stephen Sachs, director of trading at Rydex Investments, Rockville, Md., added that block trading desks have become less important to the buy side because of declining use by institutions of sell-side research.

"There are many people who no longer perceive that there's a real value add from some of the sell-side coverage out there," he said. "Buy-side institutions are far less reliant on (Wall) Street research than they were."

In the past, buy-side firms sent trades to block desks and often received equity research in return. Following the $1.4 billion settlement between regulators and 10 top Wall Street brokerage firms over their equity research practices in 2003, institutional investors cut their use of Wall Street research in favor of either in-house or independent research.

The recently passed Regulation NMS, the Securities and Exchange Commission's market structure rule, also could drive business away from block desks as it puts more emphasis on electronic trading methods, which allow investors to parcel trades.

Reg NMS will amend and extend the trade-through rule. The rule, which now only applies to listed stocks, will be applied to Nasdaq stocks as well. It will require orders that can be automatically executed be routed to the market venue with the best posted price — whether that's the NYSE, the electronic Archipelago Exchange or an alternative trading system or electronic communications network. The rule will take effect June 12, 2006, after a trial phase that will begin April 10, 2006.

Alfred R. Berkeley III is chairman and chief executive officer of Pipeline Trading Systems LLC, New York, an alternative trading system that facilitates block trading by institutions and brokers. He said Reg NMS has highlighted the issue of declining use of block desks.

"Reg NMS is trying to solve the same problem we are, but it's doing it in a way that will force order size to be even smaller," he said, explaining that while the regulation will encourage quicker trading, it does nothing to encourage participants to put up larger orders. On Pipeline, where the "book" of orders is hidden so buyers and sellers meet anonymously, the minimum order size is 25,000 shares. He said the average block that trades on Pipeline is about 50,000 shares.

But some buy-side traders disagree.

"With the passage of Reg NMS, this is a topic that's in the forefront," said Mr. Sachs, referring to block trading. "We certainly have the camp that says the block trader's a dying breed, much like the (NYSE) floor trader, but that couldn't be further from the truth in my mind."

He said even though block trading desks are being used less and less by institutional investors, they remain an important trading option.

"We do use block desks. We do think they're a valuable part of our mix of trading partners," he said. "We know the value of them and we also know the disadvantages."

David L. Brooks, senior vice president and director of global equity trading at Boston Co. Asset Management LLC, Boston, said Reg NMS eventually could encourage institutional investors to trade bigger blocks of stock.

"Over the last couple of years, post-decimalization, I felt that price discovery was not as efficient as it used to be and therefore a lot of market participants were reluctant to commit a major portion of their order in the absence of comfort in trading at a particular (price) level," he explained. "But better (market) linkages, more automation and, hopefully, centralization of liquidity will help improve the price discovery mechanism."

Still, block-trading desks are not likely to rebound to handle the amount of business they did as recently as five years ago.

George L. Rodriguez, managing director of Algorithm Trading Solutions, Newark, N.J., said block desks used to provide market "color" that was valuable to buy-side firms, but with fewer firms using the desks, that market color is lacking. Algorithm Trading Solutions provides institutional investors with trading algorithms and expertise.

"In the days pre-decimalization and pre-technology, the reason a block trader or trading desk commanded a lot of respect was the fact that they were seeing institutional order flow, and that institutional flow would help that block trading desk determine the direction of the market. That was the market color," Mr. Rodriguez said.

But as regulators continue to investigate the possible leakage of information from big Wall Street firms to either their own proprietary trading desks or to other clients on a select basis — and as some cases such as the one involving NYSE specialists advance — institutional investors are becoming less willing to give up information about their big orders because of concern that brokers will use that information against them.

On April 12, federal prosecutors charged 15 former NYSE specialists with securities fraud, alleging that they put their firms' interests ahead of investors'. At the same time, the SEC filed civil actions against the same 15 and another five former specialists. On the same day, the Big Board itself settled SEC charges that it failed to properly monitor its specialists.

Mike Plunkett, president, North America, at Instinet LLC, the institutional brokerage unit of Instinet Group Inc., New York, said because of cases like this, more asset managers he talks to are looking for ways to avoid using the big Wall Street brokers.

"There's been a number of issues in the recent past — performance issues, best-execution issues and people leveraging others' order flow to make money for themselves" — that have driven institutions to seek alternatives to traditional brokers and block trading desks, he said.

He said hedge funds have been on the leading edge of this movement, which suggests it will continue.

"Hedge funds use block trading desks less now than ever before because they're using less capital than before," he said. "They tend to be the trendsetters."

He said the need for capital from block desks has declined because of the advances in trading technology and the growth of alternative trading systems and electronic trading venues.

"In the past, it wasn't that you always needed (capital) when you were in a large-cap issue, but people put up a large amount of size to make your day easier," Mr. Plunkett explained. "But today, because we have virtually a single marketplace because of technology, you need that less and less."

Mr. Sachs at Rydex Investments agreed that concern over the misuse of information by block desks was on the rise.

"Proprietary trading by the large firms is on everybody's minds," Mr. Sachs said. "What's the reason some firms have managed to get 20(%) to 30% of their earnings from (proprietary) trading?"

But he said even though information leakage is inevitable, block trading desks can be valuable.

"It's all about risk management," he explained. "We think block desks are a valuable part of our mix of trading partners. We demand a lot of liquidity in the marketplace because of our business model. We want to find natural liquidity and block desks help us do that."

The growing need of asset managers to trade larger pieces of stock without using a sell-side block trading desk has given rise to alternative trading systems such as Liquidnet Holdings Inc., New York, and Pipeline. Other firms, such as ITG Inc., New York, and Instinet, provide crossing networks to allow buy-side firms to "cross" blocks of stock.

In addition, some sell-side firms are offering platforms to help institutions trade blocks. Last June, Banc of America Securities LLC, New York, a unit of Bank of America Corp., Charlotte, N.C., launched Premier Block Trading, an electronic system that provides anonymous, real-time block execution using the firm's own capital to take the other side of a trade.