With Reg NMS threatening to further fragment liquidity in listed stocks, US alternative trading systems are leading the way in easing the institutional pain of completing block trades by drawing out hidden or ‘dark’ liquidity.

Richard Schwartz

In need of liquid refreshment? Since decimalisation in 2001, average execution size has, according to TowerGroup, fallen 70%. This fact alone is sufficient to explain the growing popularity of venues and systems that allow an institutional trader to work large blocks of stock. Over the past few years, Liquidnet, Pipeline and Millennium have all joined ITG’s POSIT in helping large blocks of liquidity find a home.

“When people talk about fragmentation, they often miss the worst aspect of it,” says Seth Merrin, founder and CEO of Liquidnet. “It’s not really that all these different execution venues have arisen. The worst aspect of fragmentation is when a buy-side trader has a million shares that they want to do and they give the broker 100,000 shares and leave 900,000 shares sitting on the desk not providing liquidity to anyone.” Then, says Merrin, the broker that has the 100,000 shares starts feeding them into his trading system in 10,000 share slices. “Again, 90,000 shares upstairs, not providing liquidity to anyone,” he notes.

Reg NMS, the full implementation of which has been pushed back to 2007, will exacerbate the problem that fragmentation causes for institutions. “Although it’s delayed, people in the market have already begun making their systems Reg NMS compliant,” says Brian Carr, CEO of NYFIX Millennium. “The market will therefore fragment even more.” The top-of-book protection that Reg NMS is designed to provide will, he suggests, result in a scramble for small orders. “You will have to go out and get the best quote available,” says Carr. “If you post the quote, it doesn’t matter where you post it, people have to come to you.” This has two basic implications for the market: “All people routing orders have to be able to route everywhere and people posting orders can post anywhere they want. You can start an ECN in your basement and if you post the best quote, everyone has to come to you.” That will fragment liquidity even further and, Carr adds, “will reduce the size of the display that people put out there because only the top-of-book is protected.” In that environment, non-displayed, yet accessible, blocks of liquidity become that much more valuable.

An all-inclusive definition of non-displayed liquidity venues is hard to come by. Commonly referred to as block crossing systems, some of the largest reject that description. “Each has slightly different rules and each has unique characteristics,” says Richard Johnson, senior managing director, Miletus Trading, a technology-driven agency broker, that recently became one of six providers of streaming liquidity to Liquidnet’s H20 product (see below).

These systems have two basic things in common: anonymous participation and larger average transaction sizes than the listed markets. “We’ve got less breadth than exchanges, but enormous depth,” says Merrin. Institutional traders are therefore likely to stop by one or more non-displayed liquidity venues on their way to or from market, depending on the nature of the order they are working.

Rules of entry will play a role in the choice of venue. Liquidnet membership is restricted to buy-side firms, NYFIX Millennium is sellside only, while Pipeline and POSIT have a mixture of buy- and sell-side participating directly in their systems. These distinctions are, however, not set in stone. Liquidnet H20 allows market- bound flow from certain agency brokers to match with its buy-side members. NYFIX, meanwhile, owns an introducing electronic broker called NYFIX Transaction Services, one of whose functions is introducing firms directly into Millennium. “Even though we’re sell-side only, there are numerous buy-side firms that interact their orders directly into Millennium through an introducing broker,” says Carr.

The average trade size on Millennium is smaller than on the other crossing networks, though, says Carr, it is bigger than on the exchanges. “It depends how you define a block,” says Carr. “Is more than 10,000 shares all you’re interested in, or are you really interested in non-displayed liquidity and not leaving a footprint? In Millennium, we can do a bit of both. For a 50,000- share order, for instance, we’re likely to match one block of 25,000 shares and fill the rest with a number of pass-through order flows.” Carr describes Millennium as delivering hybrid non-displayed liquidity in a continuous matching function to clients. “We don’t just match big blocks,” he says. “There are some symbols that there is no natural other side for.”

Execution models among the venues also vary. There are essentially two kinds of technology underpinning the block trading of nondisplayed liquidity. One is negotiation technology of which NASDAQ’s Selectnet for brokers was an early example, subsequently replaced by Supermontage.

Of the current systems, Liquidnet, selects partners for negotiation by sweeping participant OMSs and then allows the two sides to enter into one-to-one real-time negotiation. In 2004, approximately 50% of all Liquidnet executions were at the midpoint of the national best bid and offer (NBBO). Other systems treat bids and offers input as firm orders, in some cases containing an auto-execution function.

Pipeline offers a bulletin board system based on minimum order size. Once an order is input, it is considered executable. “ECNs have been very successful at addressing smaller orders, but have not been successful at providing an electronic marketplace for giant trades,” says Fred Federspiel, founder and president of Pipeline. “We have created a marketplace that couples the block market with the electronic marketplace.”

For the first quarter 2006, average daily volume in Pipeline climbed 17% above the previous quarter, and 312% above the prior year’s first quarter. Growth is coming from both new customers and increased volumes from existing users as their comfort levels increase. “Pipeline allows all types of traders,” says Federspiel. “The threshold for entry is the minimum size and the commitment to execute,” he comments.

A crowded space?
Market share estimates by TowerGroup from November last year, based on average daily volume of over 98 million shares, give Liquidnet 37% of the total, ITG POSIT 36%, Pipeline 15% and NYFIX Millennium 12%.While POSIT, created in 1987, was the first to show the value of a large block crossing network to the market and has retained a loyal following, the other three have all produced growth figures that their investors can be happy with. Unlike the traditional broker market, the major block crossing networks do not seem to view each other as direct competitors. Rather they are, as a group, more of a threat to the listed markets. Even then, however, they are not competing for retail flow.

“Non-displayed liquidity venues are a crowded space in the sense that if you wanted to enter it with a new matching solution, it would be competitive,” says Carr. “To be a new dark liquidity provider, it would be tough to get that initial liquidity momentum going. But the existing providers are all showing good growth rates. It’s a very successful part of the market right now. Anonymous non-displayed liquidity providers are very much in vogue.”

Liquidity hunting
For their success to be sustained, each system is keen to attract additional sources of ‘dark’ liquidity: essentially, pools of equity that are in theory available to trade but are not currently in play. Liquidnet has, for example, over the past eight months, been introducing a new streaming liquidity service, H20, which turns the traditional exchange model on its head. Rather than institutions going into the market seeking to fulfil orders from the retail flow that it finds there, it allows execution-bound order flow from a select number of agency brokers to stop off on its way to market in search of a match. The model in fact draws on the traditional role of a wholesaler as a provider to the retail markets. Currently, nine firms have been selected as streaming liquidity providers (SLPs): Bloomberg Tradebook, BNY Brokerage – a subsidiary of The Bank of New York – Instinet, FutureTrade, Miletus Trading, Piper Jaffray, EdgeTrade, UNX and Goldman Sachs Execution & Clearing – an agency subsidiary of Goldman Sachs.

Some query whether this is the start of a breach in Liquidnet’s strict buy-side only ethos. “I think there’s more behind H20 than simply streaming liquidity,” suggests Joe Gawronski, chief operating officer, Rosenblatt Securities, an agency-only execution firm. “I think it’s Seth’s way of letting in the sell-side. The reality is that 80-90% of commissions are tied to research as long as bundling is still the norm. It’s very tempting to let in the sell-side where the majority of the order flow ends up in the course of fulfilling all of the research obligations.”

The key for Liquidnet, says Gawronski, is not to alienate the buy-side. “Of the systems they’re going to work with, some are used by both agency-only brokers and brokers that trade as principal,” he notes. “Are all BNY/Sonic or Goldman Sachs/Redi users going to be allowed to put orders through H20 or is there a way to ensure that it is all agency-only business?”

On this point Merrin is emphatic. “We should provide as much protection as possible to our members,” he says. “It took us three years to get this product to market because we put in every possible safeguard against gaming we could think of.”

When SLPs sign up to use the system, they have to commit contractually not to send through any proprietary flow. “The obligation is on them to exclude it and if they don’t and we find out we’ll kick them out,” says Merrin. “If they really wanted to get around that dishonestly, they possibly could, but the risk to their business would be high.” There are also strict rules on the use of algorithms to interact with the Liquidnet pool. “There is simply no ‘prop’ flow allowed,” says Merrin. “Anything that comes into us has to go through an order router; there has to be a black box connection to us. If any of the SLPs execute liquidity against a Liquidnet member, their customers cannot know that.”

The attraction to the sellside is clear. “When we offer our liquidity pool with midpoint execution to other brokers, why would they object?”Merrin asks. For Johnson of Miletus, a firm that has traditionally specialised in trading less liquid stocks through sophisticated quant strategies, SLPs are quite happy with the conditions imposed. “We’ve been talking to Liquidnet for a year or so,” he comments. “They are willing to bring in the sell-side, but on their terms and we’re proud to be in the first wave of SLPs. For us, it’s another liquidity destination on the way to market, but one of particular value as we specialise in small to mid-cap stocks.”

Liquidnet is also looking to expand the number of SLPs. “We’re talking to another 10 or so,” says Merrin. “We don’t charge them anything and we offer mid-point execution. I can’t see why they wouldn’t want to join.”

Millennium sees new broker algorithms as an attractive liquidity source. “Other brokers can interact with Millennium through the use of algorithms in two ways,” says Carr. “If it’s a VWAP or other benchmark algorithm that’s sending orders out to street exchanges, they can expose the orders to Millennium on their way out, looking for either price or liquidity events,” he notes. “The second way, which is probably where we’ve seen the bulk of the growth, is as people develop new smarter dark liquidity algorithms, Millennium is a natural place to interact with.”

As a pioneer of anonymous trading, POSIT showed that orders could be executed without information leakage. It is one of a raft of trading applications that ITG offers in both an integrated and modular fashion. ITG has now established a joint venture with Merrill Lynch to create Block Alert, an independent, anonymous block crossing service powered by POSIT. The venture will bring together Merrill Lynch’s global distribution with ITG’s technologyenabled trading. “Through this new joint venture, ITG’s clients will have access to a greater global pool of liquidity made available by Merrill Lynch’s distribution network,” says Ray Killian, chairman, president and CEO of ITG. “This will increase matching opportunities while maintaining the confidentiality and anonymity.”

Crossing for transitions
One obvious segment of business that non-displayed liquidity venues should be able to attract is portfolio transitions. Indeed, respondents to The TRADE’s latest survey of transition management services (see page 79) on the whole are upbeat about the use of both internal and external crossing. “Public crossing networks such as POSIT and Instinet, IOIs from brokers and other broker order flow are just a few of the liquidity sources we tap into,” says Josephine Defty, assistant director, Implementation Services at Russell. “Over the last three years external crossing has accounted for approximately 30% of trades.” However, she points out, “We set the trading strategy based on minimising implementation shortfall and controlling the risks of the event – not based on maximising crossing. As such, when implementing the chosen transition strategy we try to cross as much as possible when we need to trade … but we will not significantly change that strategy just to try and incorporate more crossing opportunities.”

Mellon’s survey response also expressed reservations about a whole-hearted embrace of external crossing. “It is easy to be seduced by the apparent simplicity and low cost of such programmes,” said the bank. “For example, maximising the crossing can lead to higher risk during the transition, particularly where the highly liquid stocks cross leaving a high risk/low liquidity residual, and a higher total cost.”

Generally speaking, however, there is no best practice in the integration of non-displayed liquidity venues into broader trading strategies. It is down to the judgement of the individual trader. “There’s no magic way to work the block liquidity,” says Carr. “Whether it’s 50,000 shares of IBM or 20,000 shares of Outback Steak House. You really have to get your order exposed in all these non-displayed locations or in one location that can aggregate all this nondisplayed liquidity,” he comments. “One of the focuses of Millennium is to try to aggregate the non-displayed sources of liquidity.We’re trying to get connected to as many other liquidity pools as we can.”

Future volumes
According to TABB Group, the combined crossing network volume in the marketplace has grown to 9% of total equity trading volume. It projects an annual increase of 3% a year for the next several years.While TABB Group questions the ability of the market to support the current number of blind crossing networks, which they put at up to 15. Yet a number of brokers are now looking at converting their internal crossing capabilities into ATSs, including Credit Suisse’s CrossFinder. This suggests that more block liquidity venues will arrive before consolidation being in earnest.

Another possibility is that institutions will push for more effective direct links among the various block liquidity venues. The contours of a new institutional market will then begin to emerge.Merrin finds this thesis plausible, at the very least. “The institutional marketplace represents 70% of the volume,” he says. “The way I see it happening is that in a few years, most of the institutional volume could be getting done among ATS. Once it’s all captured in the system it is then theoretically accessible by other forms of liquidity”

For Gawronski, whatever opportunities he is offered to access non-displayed liquidity he is likely to take up. “We are already big users of Pipeline and NYFIX Millennium and if allowed to access H20 through Sonic we clearly will,” he says. “Your most sophisticated desks seek access to as many pools of liquidity as possible, especially when they’re not being charged. Even if I get charged, if that’s where the liquidity is, that’s where I’ve got to be to service my customers.”