Block trading: horses for courses
One component of transition management that has grown in importance is block trading. As its name implies, this involves the trading of large blocks of shares between institutions.
Historically, the problem with block trading is that there is no wholesale market for shares. Large institutional investors trade in the same market place as small retail investors. So any block trade is likely to have an impact on the market.
One solution is to go outside the market altogether. Liquidnet , a New York broker/dealer with operations in Europe, has created a electronic market place for block trading using the internet.
Seth Merrin, founder and chief executive officer of Liquidnet, says there is a growing demand for this kind of trading. “Institutions have outgrown the market structure’s ability to handle their business efficiently. So every time the institutions go into the market place they move the market.
“There’s a huge growth in assets which translates to a large growth in the size of the positions that institutions have to buy and sell, and at the same time you’re facing declining amounts available on the exchanges, both in the US and certainly all over Europe.
“Public market places are fine for retail, but cannot handle two very different constituencies efficiently. The retail investors may want to buy 100 shares and they can go on to the exchanges with no problem They get an immediate execution and know exactly the price that they’re going to trade at.
“When the institutions go into the market place they do not get an immediate execution and they have no idea what the ultimate price that they’re going to be able to buy and sell their position at.
“That’s the sign of an inefficient market place. You would think that the exchanges around the world would be the perfect capitalist environment. For every buyer there’s a seller. The problem is that the institutions do not make their supply and demand information known to the public markets for fear of predatory traders.
Merrin says the solution is to create an electronic wholesale market for institutional investors. “We say forget about retail. Let’s just put buyers and sellers in a virtual room together so they can trade their positions in complete anonymity and in the size in which they need to trade.”
Liquidnet has expanded its operations into Europe and now has some 100 members trading assets in 12 European countries worth e2.9trn.
The system faces competition from other alternative trading systems, principally POSIT, the intra day equities crossing system of ITG. “We’re not the first ones to recognise there’s a problem,” says Merrin. “There have been a lot of firms that have come before us and after us and have simply not gotten it right. You need a critical mass of liquidity in which to operate in order to be viable. So that’s what we’ve done. We have been able to create a virtual pool of liquidity where on day one we were able to provide large executions to our members.”
Merrin envisages a scenario where very large US and European pension funds could circumvent the equity markets altogether with internet block trading. “Client sponsors have talked for years about creating their own networks so they can trade among themselves. They are saying that if they have a million shares to buy and someone else has a million shares to sell, why don’t they just cross it? Why do we have to go through the market place and incur all this expense? Why indeed?”