Media Room

The Block Trade is Dying. Long Live Blocks

Monday, October 19, 2009

John Hintze

Institutional investors' ability to execute trades of large blocks of stock electronically has dropped notably over the last year and a half-as small trades under 400 shares have increased-with even top block-trading venues seeing a reversal as unlikely.

The reasons? Algorithms slicing big trades up into lots of small ones executed in rapid-fire fashion keep improving, and fears of big swings in stock prices linger.

"I don't see trade size ever coming back, especially with high-frequency trading making up 60% of the market. It's a traders market right now," says Alfred Eskandar, head of U.S. equities and a founding employee of Liquidnet Holdings.

Liquidnet is one the top block-trading venues designed to match large orders without displaying quotes-a so-called dark pool. Its average trade this year through August fell to 50,790 shares, from 54,920 during the same period in 2008.

Eskandar says the average trade size for September fell 9% compared to a year earlier, although it remained above 50,000.

The firm's average daily trading volume also is down. In August, Liquidnet handled 55.3 million shares a day compared to 63.9 million shares in the same period last year, a 14% drop. For the first eight months all told, the average fell 20%, to 60.4 million shares from 75.8 million shares last year.

Liquidnet's volume numbers include both sides of matched blocks and only one side of trades executed through H20, a sister venue in which blocks waiting for matches in Liquidnet can be eaten away by small orders streaming from official liquidity providers.

Over the last decade, Liquidnet's average trade size has ranged from 40,000 shares to more than 70,000. More recently, Eskandar says, though, the size hasn't dipped much. "It's hovered around 50,000 and it's probably going to stay there,'' he says. "It's not going to go back to 70,000."

Investment Technology Group's Posit Alert, a block-matching facility that monitors institutions' trade blotters for potential matches in a similar fashion to Liquidnet, saw an average trade size of 39,100 shares in second quarter. The second quarter of 2008 was not much higher at 40,000, but the quarters before and after were each at least 42,000. ITG declined to provide Alert's volume. However, the Posit suite of products, including its point-in-time match as well has a small-order matching engine, executed a daily average of 48 million shares in the second quarter, counting both sides, up from 45 million a year ago. Rosenblatt Securities estimates the Posit family's average trade size to be 6,000 shares

Bucking the trend, Pipeline Trading's average trade size over the last month was 53,856 shares, up from 45,517 shares during the same period two years ago, according to Fred Federspiel, the firm's president. Federspiel attributes that increase to diligently ensuring members' priority is block trading, and establishing volatility-protection measures two years ago.

Nevertheless, the executions generated by Pipeline's algorithmic switching engine, enabling customers' orders to interact with the overall market, are taking up an ever growing share of its currently daily average volume, Federspiel says. He adds that Pipeline's volume, at 27 million shares over the last month counting both sides of the trade, has fallen 3% from the same period a year ago.

In fact, Rosenblatt Securities estimates that Liquidnet, Posit and Pipeline together executed 0.64% of consolidated U.S. equity volume in August 2009, compared to 1.04% in February 2008.

In another measure of less block-trading activity, Liquidnet's 2009 executions of blocks that are one million shares or greater numbered 126 as of last week, compared to 331 for all of 2008. "We'll probably end up doing 20% or 30% fewer prints of that size this year,'' Eskandar says.

Liquidnet's execution volume follows the path of its large, mostly traditional institutional investors, including insurance companies and pension funds. "Feast or famine, our volume is based on their prosperity. When you see outflows from active fund managers, those are my guys," Eskandar says.

Growing inflows into those funds should, therefore, increase execution volumes at the block-trading venues, but fundamental market changes may continue to stunt the size of large trades.

Finding a "natural" match for large block orders, which can range anywhere from 10,000 shares to more than one million shares has long been the goal of institutional investors.

Such transactions typically trade at the midpoint of the bid and ask spread, providing price improvement. If they're done stealthily, executions can occur before opportunistic market participants can wreak havoc with the stock's price and the trade's outcome.

Laurie Berke, an analyst at Westborough, MA-based Tabb Group, notes buy-side investors participating in the consultancy's annual buy-side survey say they would like to return to an environment where larger blocks are more easily executed.

"But if everybody truly felt that way, we would be trading more blocks," she says.

Tabb's research instead, points the other way. The firm surveyed 63 head traders at traditional long-only buy-side firms for a 2008 study, and found only 15.8% of their shares executed daily were in blocks, down from 19.7% the year before.

Those firms managing more than $150 billion in assets said 19% of their average daily shares were executed in blocks of at least 10,000 shares, with 52% of those executed through electronic venues. By 2010, they anticipated 64% of those blocks to be executed through electronic venues.

That increase now appears unlikely. Meanwhile, those same institutions told Tabb that the percentage of their orders going through algorithms increased to 24% in 2008 compared to 22% the year before.

Berke says one theme emerging for the 2009 survey, which gets released in November, is that the extreme stock market volatility last fall and early this year has caused block jitters. "People fear putting up a block and having the stock's price move adversely against them," she says.

Although still crunching the numbers for this year's survey, Berke says, "The response to volatility was algorithms, not crossing blocks, and that behavior continues. Algorithms continue to enjoy significant year-over-year growth rates, whereas block trading does not."

The increased popularity of algorithms may ultimately be the biggest impediment to block trades regaining their size.

During periods of high volatility, volume-weighted average price (VWAP) algorithms are attractive because they break up larger orders into small pieces and take the average of their execution prices over the day, mitigating the risk of big price fluctuations. And the algorithms keep getting more sophisticated, overcoming some of the concerns they once presented such as whether they could find liquidity efficiently in a fragmented market and disguise the intent of the algorithm user.

Chris Heckman, managing director responsible for U.S. sales at ITG, said that continuous markets that are largely algorithm driven now provide many of the benefits of block trading, such as price improvement and more efficient executions, even if average trade sizes fall.

"Clearly the overall market has become much more continuous, much more electronic and more high frequency," Heckman says.

The block matching engines recognized that trend several years ago and began introducing mechanisms to give customers' orders the ability to interact with the continuous electronic markets and take advantage of that liquidity while waiting for a natural match. ITG customers have had that ability for several years through its Posit Now service, and in March the firm introduced Posit Marketplace, which unites it block-trading services with those designed more for algorithmic trading.

Eskandar says H2O has a 150% increase in execution volume year over year, although third quarter volume was down somewhat from second quarter. The block-trading venues declined to say how much the share of non-block, small-trade executions has grown compared to block trades. However, they all acknowledged that algorithms have come of age.

"They've gotten better and they're more respected. It's almost impossible to work an order these days without that electronic component," Eskandar says.

Even in dark pools, where institutional investors come to anonymously buy or sell big blocks, are less of the action.

"We have definitely seen a movement in the dark-pool space away from traditional, institutional block crossing networks and toward continuous, algo-friendly, small-size pools," says Justin Schack, vice president of market structure analysis at Rosenblatt Securities.

Displaying how uncertain the fate of block trades remains, however, Joe Gawronski, president and COO of Rosenblatt, says he "would be even bolder in saying the age of the block has passed. While many buy-siders lament it, the fact is as a group they don't execute very much in blocks any longer."

Meanwhile, Richard Rosenblatt, the firm's founder, takes a more cautionary tone, noting that the need for large trades will remain but the mechanisms to execute those trades may evolve. "When institutional volumes go through their next growth period, new liquidity sources will be needed, and it is very possible that a new kind of block market might emerge," Rosenblatt says.

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