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 Commissions 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 dont 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 dont know how well institutional flow is counted. We dont 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 dont have the conflicted environment here, so our clients dont 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 doesnt 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 wouldnt 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 dont 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 cant, they wont 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.
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.