Too much information, some investors fear

Regulation NMS could scare away institutional investors from open markets, just as it ushers in an era of true transparency for U.S. markets.

The Securities and Exchange Commission’s market reform takes effect March 5 for all 10 U.S. exchanges and three electronic communications networks that must connect to each other and monitor their electronic quotes in real time to ensure that trades are always executed at the best price.

But for institutional investors such as money managers and internally managed pension funds, the issue is to avoid signaling the large portfolio positions they intend to trade because of the adverse price reaction this would naturally trigger.

“Transparency has a positive side and a negative side. There are times when an institution wants to keep its orders close to the vest and not show them in the primary market. This is particularly the case with very large or information-sensitive orders that institutions don’t want to show and for which they need venues others than an electronic order-driven market,” said Paul Davis, a former managing director at TIAA-CREF Investment Management LLC, New York, who took an active part in the debate leading to Reg NMS.

Mr. Davis, who works on special projects for TIAA-CREF, noted the recent volume growth at a number of pure agency brokers that operate members-only closed alternative trading systems. Money managers have shown a clear preference for agency brokers, which do not conduct any proprietary trading and have no perceived conflict of interest with their clients.

“Some dark books have grown rather dramatically in the last six months. Their volume is estimated to represent 20% or so of the total volume, but it might be a higher percentage because we don’t know how well institutional flow is counted. We don’t have a good handle on it,” Mr. Davis added.

Some orders off the books

A substantial part of institutional order flow that is difficult to gauge in terms of overall volume is related to transition management. A pension fund that changes money managers or asset allocations often must exit large positions and set up new ones. Many turn to firms that specialize in transition management that can manage the risk related to the complex exercise with little or no market exposure.

“A lot of people come to State Street because of the large liquidity pools we have,” said Ross McLellan, senior managing director at State Street Global Markets LLC in Boston, which operates an agency transition management unit. “We don’t have the conflicted environment here, so our clients don’t have to worry when they trade with us that the information can come back to haunt them or that we are trading against them.

“There is no commission. There is no spread. (State Street doesn’t unbundle the cost related to crossing orders internally from the overall transition cost.) We have basically the largest dark liquidity pool in the world in an unconflicted environment, given the size ($400 billion annually) of our transition business,” added Mr. McLellan.

Mr. McLellan wouldn’t estimate how many shares his firm crosses internally, noting the trades are not reported to any exchange because shares are directly transferred between custodians. Given the size of such transactions, orders crossed off the books could represent more than the estimated 20% of overall volume.

Timothy Olsen, senior vice president and head equity trader at ICM Asset Management in Spokane, Wash., predicted that the ability to protect anonymity could become a make-or-break factor for competing trading venues. ICM has $1.9 billion in assets under management, invested in part in small-capitalization stocks with limited liquidity.

“We have used crossing networks for the last few years, and I don’t see this changing with Reg NMS,” said Mr. Olsen. He said information leakage “is something that I have been guarding against for the past 19 years. The exchanges will only be successful if they can protect anonymity, and if they can’t, they won’t be in business in two years from now.”

Kevin Pilarski, a partner at Kilkenny Capital Management LLC in Chicago, said his firm, which manages $200 million in biomedical technology stocks, can face a real challenge on open markets due to the specific nature of the portfolio.

“If you are in an illiquid small-cap name, crossing networks do a very good job at maintaining anonymity and get you the liquidity when you need it,” he said. “Going to a crossing network or an exchange is a function of where you find liquidity.”

Bifurcated markets

Even before Reg NMS’ effective date, institutional orders had been increasingly moving to venues designed on an opaque model, with no display of order price or size.

If the trend away from open markets continues, the U.S. equity marketplace could end up looking like the bifurcated European model, where small retail orders drive the price discovery on open exchanges, while size discovery takes place on various alternative venues.

Robert Schwartz, Marvin M. Speiser Professor of Finance at the Zicklin School of Business at Baruch College in New York, noted Reg NMS has prompted major changes that could boost the growth of off-exchange trading.

“The NYSE floor performs a function that is separable from an electronic book. The demand for that function will continue to exist whether the floor exists or not. The question is: Where will it be expressed? I anticipate this will be in upstairs trading or internalized,” Mr. Schwartz said.

Mr. Schwartz, Mr. Davis and Michael Pagano, associate professor of finance at Villanova University in Villanova, Pa., wrote a paper published last fall in the Financial Analysts Journal saying that after the German markets endorsed an electronic format, volume split roughly 50-50 between on-exchange and off-exchange trading.

Executives at major Wall Street firms see rising odds of this bifurcated market scenario playing out in the U.S., and do not want to idly watch their competitors in the pure agency segment snatch a growing market share of their institutional orders. As an answer, they are setting up their own agency solution.

Citigroup Inc., Goldman Sachs Group, Inc., Lehman Brothers Inc., Merrill Lynch & Co. Inc. and Morgan Stanley co-founded BIDS Trading LP, a separate agency-only broker-dealer that operates the BIDS ATS that will anonymously match large blocks of shares. Five of these firms are backing a similar venture, called Project Turquoise, in Europe.

BIDS Trading General Counsel Richard Levin said: “Whether the Chinese walls are thought to be high enough, it’s the perception that matters. With BIDS, we will focus on maintaining the confidentiality of information. Anonymity is a key component of what we are trying to do here, an open model with a very strong focus on confidentiality of information and advanced technology.”

Exchanges will undoubtedly suffer if their clients, the major Wall Street firms, lose trading business to those various venues such as BIDS. Nasdaq Chief Executive Officer Robert Greifeld took that threat very seriously when he offered to buy the London Stock Exchange at a price shareholders deemed too low.

“We know that every asset has a fair value,” Mr. Greifeld told an analysts’ meeting following rejection of the Nasdaq bid. “Our assessment of fair value was influenced by the competitive forces that the regulatory change known as MiFID will introduce to the European market. While the impact of MiFID is not clear at the present … it is impossible to ignore its potential impact in 2008 and beyond.”

Like Reg NMS, MiFID, which stands for Markets in Financial Instruments Directive, paves the way for greater transparency and increased competition among the exchanges and other venues.

Challenging environment

Market regulations often come with the law of unintended consequences, as Nasdaq painfully found out at the beginning of this decade when new rules left the electronic market at a disadvantage against the ECNs.

Whether the newly electronic NYSE will suffer a similar fate under Reg NMS may be open for debate. Still, there clearly is not enough volume in the U.S. stock market to support 10 stock exchanges plus three ECNs that post their quotes on NASD’S alternative display facility, particularly if more institutional flow moves off exchanges.

“While we may all agree with the goals of increasing liquidity and the fairness of our markets, the fact is that no one knows whether this massive regulation will work,” said then-SEC Commissioner Cynthia Glassman, when she cast her vote opposing Reg NMS in April 2005.