Market Consolidation: An End to Fragmentation?

The No. 1 challenge faced by buy-side head traders - by far - is market fragmentation, according to a recent TABB Group report. But what is fragmentation; why are traders concerned about it; and why hasn't all the technology that we've created and the recent market consolidation fixed the problem?

Being a guy, when I think of fragmentation, I think of grenades - devices that explode, breaking into multiple shards that cannot be glued back together. This analogy is not so different from the markets - a unified Nasdaq blowing up into a dozen ECNs and spreading liquidity across them, and decimalization blowing up the liquidity previously centralized at each sixteenth of a dollar. All of this liquidity virtually is impossible to glue back together.

But, haven't DMA and algorithms fixed the problem? Can't we use the technology to consolidate liquidity across markets? Can't we use algorithms and smart order routing to take large buy orders, break them up and route the smaller orders to the appropriate trading venues? And isn't the consolidation of market venues - Nasdaq's acquisition of Brut and now Instinet, and the NYSE's proposed merger with Archipelago - going to consolidate liquidity and virtually eliminate fragmentation?

I don't think so. In fact, the tools and technologies that we have used to control and manage our trading better will fragment the market further, regardless of the number of trading ECNs and market centers.

Fragmentation, according to buy-side traders, is not necessarily the challenge of finding large liquidity across trading venues - it is the challenge of finding large liquidity, period. But, if all of the ECNs and trading venues were to consolidate into one venue, wouldn't the splintered liquidity miraculously be consolidated into a larger single pool? Probably not.

Liquidity is not splintered because there are multiple trading venues; liquidity is fragmented because of decimalization and traders' desires to hide their intentions.

If there were a single pool of liquidity, would traders still want to hide their intentions? Absolutely. And traders today have a wider array of technologies to help them. Aggregation/DMA technologies enable traders to manage reserve quantities and refreshment points better, regardless of the execution venue. And trading algorithms - probably the largest culprit of fragmentation - break large block trades into micro-trades, spreading execution over hours or days. Nowhere can you find the large block; you can find only little pieces, as the average equity execution now hovers below 400 shares per trade.

But what about crossing networks, those liquidity discovery tools that help large investors find other large investors? These tools are great - if you can find a trading partner. But a trading partner often is unavailable. And many of these platforms are not connected to traditional markets, which increases fragmentation and makes it more difficult for traders to find size in traditional venues.

So, is there an answer to fragmentation? Probably not. The solution lies in an inescapable riddle: The only way to reduce fragmentation is to display greater liquidity; but displaying greater liquidity disadvantages your execution by providing greater opportunity for others to step in front of your order, increasing market impact.

While we complain about fragmentation, that may not be the real issue. The real issue lies with reducing market impact, trading costs and commissions. As buy-side traders become more sophisticated and cost conscious, the hide-and-seek technologies that they use to reduce cost are the same technologies that they curse. And while the fragmented markets are consolidating, the grenade that actually fragmented the liquidity does not look like it can be pieced back together.

Larry Tabb is founder and CEO of Westborough, Mass.-based TABB Group, a financial markets strategic advisory firm. [email protected]

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