A Chip Off the Block
The New York Stock Exchange's specialist-driven, open-outcry model, battered by trading scandals, is scheduled for an overhaul. The exchange plans to modernize its trading model with the upcoming Hybrid system, which, in part, is meant to draw back the large orders that have migrated to newer, electronic block-trading systems. For their part, traders seem willing to give the Hybrid market a chance, on the essential condition that it offers the kind of anonymity and order protection that has become the hallmark of electronic players such as Instinet's Crossing Network, Investment Technology Group's (ITG) POSIT, Liquidnet and Harborside+.
Because many buy-side firms feel that the current NYSE system favors the interests of specialists and floor brokers over those of institutional investors, block trades have been migrating off the NYSE floor. The current 1,099-share limit on the NYSE's Direct+ electronic execution system isn't practical for block trades, which tend to be comprised of groups of 10,000 shares or more; traders are forced to break up the orders or send them to floor specialists through the Direct Order Turnaround (DOT) system, which tends to provide slower executions. The Hybrid proposal eliminates the threshold size for automatic electronic executions at the NYSE, but it still would involve the intervention of specialists. If a stock price moves either 25 cents or 1 percent in either direction for 30 seconds, the order would be kicked out to a specialist, who would work the order to find the best price.
"Once we have the Hybrid market, there will be an increased willingness to display bigger size on NYSE, which will lead to higher average executions and more blocks being traded on the NYSE," says John Wheeler, head of U.S. equity trading at Kansas City, Mo.-based American Century Investments. Wheeler estimates that about 15 percent of his trades above 10,000 shares is executed on electronic block systems. "There is a distinct possibility that [the Hybrid system] would mean less traffic for the crossing/block networks," he continues. "How well the exchange polices the behavior on the floor will determine whether this really works."
In April, 15 specialists were charged with "front running" customers, or trading against customer orders for the specialists' own profits. This is the sort of information manipulation that has plagued the NYSE and gave rise to the block-trading networks in the first place. The NYSE's Hybrid system is meant to provide traders with immediate executions of large orders - the lack of which has driven them away from the trading floor - together with the traditional price improvement for which the exchange still is the superior source in many eyes.
At press time, the NYSE announced its planned merger with Archipelago. An NYSE spokesman declines to comment on how the proposed merger might affect block trading. "We have not fully examined Archipelago's IT assets, but we will have more details about the transaction as we go forward," he says. For now, the NYSE plans to continue developing the Hybrid platform as previously stated, the spokesperson says.
Today's block and crossing networks grew out of structural issues stemming from decimalization. Liquidity in the equity markets is more difficult to obtain - the volume that used to be concentrated at every one-sixteenth of a dollar is now parsed at every penny. Trading blocks of shares has more market impact now because traders may have to accept five different quotes, for example, whereas before decimalization they need only have accepted two quotes.
In the process of seeking liquidity, traders potentially have more "conversations" with the marketplace, either verbal or electronic, thus giving competitors more clues as to the intention of trading activity and an opportunity to move the market against the initial bidder. As such, many buy-side firms have turned to electronic block trading to trade large volumes anonymously.
The NYSE, however, still trades more block volume than any of the electronic networks. In March 2005, the NYSE reported 10.988 billion shares traded in lots of 10,000 shares or more, averaging 354.5 million shares per day. Still, there is considerable institutional volume for the NYSE to win back.
POSIT is the oldest and largest of the block crossing systems, with 550 users trading about 21.9 million shares a day. Liquidnet, which more than doubled its average daily volume from 2003 to 2004, handles about 340 users trading 20 million shares per day. Instinet Crossing Network trades about 11 million shares per day. And Harborside has 117 users and claims to support the largest average daily trade size - 72,000 shares.
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