Building Blocks for a Post-Reg NMS World
By Sayena Mostowfi, TABB Group
Originally published on TABB Forum
Many buy-side traders would like more opportunities to trade in blocks. But most current solutions have inherent limits in how much block trading they can facilitate. To unlock the potential for the block, the next generation of trading tools will need to address multiple requirements that are often at odds with one another as well as the business models and complexities of a post-Reg NMS equity market.
The buy side continues to value block trading as it did a decade ago, and yet the block percentage of overall volume has dropped significantly in the wake of the market structure changes of 2001-2007. While new solutions adjusting to a fragmented post-Reg NMS environment have enabled block trading volumes to stabilize, significant gaps remain between what could potentially trade as blocks, the volume the buy side wants to trade in blocks, and the actual block numbers.
TABB chart 3 20 14
With the rise of electronic trading, buy-side traders have adopted a variety of tools that attempt to provide anonymity and avoid information leakage. But the additional goal of sourcing block liquidity, naturals in particular, is incredibly valuable and extremely difficult to accomplish. There have been many attempts to deliver a block trading platform, each employing a combination of techniques to optimize order protection and matching rates.
Cracking the block market, however, is a tall order, and the past decade has seen many attempts to solve for it. In order to facilitate block trading, a solution needs to try to solve for multiple requirements that are often at odds with one another, including enabling trusted counterparties and allowing for anonymity, sourcing liquidity and paying for services, quick matching engines and seamless workflow integration, and finally marrying electronic messaging with traditional sales trading.
Even within ring-fenced communities or with a trusted counterparty, the buy side has learned that it pays to be paranoid. The outstanding trust issues lead some traders to prefer to rein in their exposure to certain types of venues (limiting exposure to liquidity) and other traders to use all of them (limiting order size). Market macroeconomics also plays a role in the ability of traders to bring block-sized orders together. There is a dynamic and complex combination of factors that go into block trading volumes that cannot be viewed in a vacuum.
In addition to trust and seeking liquidity, buy-side firms must wrestle with the challenge of funding (via commissions) specific relationships for broader brokerage services. Thus, any attempt to increase block trading from its current levels has a better chance if it works within the traditional buy-side and sell-side sales and trading arrangements. The culmination of these reasons results in the dispersion of methods in executing block-sized order flow.
There is no technological panacea that will make trading more trustworthy. However, there are mechanisms that offer better protection to the buy side that will increase the number of interactions the buy side would have with its trusted counterparties. While early successes have been shown to have a ceiling in terms of the amount of block liquidity that can be brought under the roof of an independent venue, it is hard to imagine what buy-side traders would have done without them. New, innovative solutions – not targeted regulation – will need to address the business model tensions and market complexities.