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2004 Outlook: Electronic Trading in Stocks Reaches the Tipping Point

Look out for more efficiencies and disruption in 2004 as Nasdaq and ECNs make a play for listed stocks. TowerGroup predicts program trading, algorithmic trading and black-box market making are here to stay.

Judging from the numbers, electronic trading continues to transform the equity markets, according to Robert Hegarty, vice president securities & investments at TowerGroup.

With electronic-communications networks (ECNs) garnering nearly 50 percent of the volume in Nasdaq stocks, and signs they are taking steps to penetrate listed-stock-trading, Hegarty says, "I think the industry is reaching the tipping point for electronic trading."

Though Hegarty says it will never reach 100 percent, electronic trading is the favorite method. In an opinion piece looking ahead to 2004, Hegarty wrote, "Black box trading will replace market makers en masse" and "the NYSE specialist model will come under direct attack after a year of upheaval, forcing member firms and investors to move to electronic alternatives whether at the Big Board or not." Black box market making is a computer program, in which users enter information and criteria and the system automatically generates two-sided bids. Market makers are then prepared to execute against these two-sided bids.

One of the catalysts that could cause member firms to send order flow in listed-stocks to electronic systems is potential repeal of the trade-through rule by the Securities and Exchange Commission (SEC). Today, the rule requires traders to send orders to the market with the best price via the InterMarket Trading System (ITS). If the rule is eliminated or changed, traders could base their order-routing decisions on other criteria such as speed and fill rates. "I hear both proponents and opponents of repealing the trade-through rule. Given the amount of industry discussion, it's more likely now than it was six months ago," says Hegarty.

Nasdaq plans to allow market participants to trade listed stocks via SuperMontage, its automated execution system, by the middle of the first quarter of 2004, pending SEC approval. As a sign of that, Nasdaq announced this week that it will waive hourly fees for testing of SuperMontage for exchange listed-trading functionality. Nasdaq already offers exchange-listed trading via the Nasdaq InterMarket running on the Computer Assisted Execution System (CAES) platform.

Another "harbinger of electronic trading really taking hold" is the increase in program trading on the New York Stock Exchange, which ranges around 40 percent of average daily volume, says Hegarty. He also cites the decline in U.S. trading-desk personnel from the heyday of March 2000 when there were 19,000 equity-trading positions in the United States, to the current level of 15,000 or 16,000 positions. Program trading, which encompasses a wide range of portfolio-trading strategies, involves the purchase or sale of a basket of at least 15 stocks with a total value of $1 million or more, according to the NYSE's definition.

Another indication that electronic trading is here to stay is the evolution of algorithmic trading or rule-based trading to match a benchmark. Algorithmic trading uses complex trading analytics to work orders of any size and break them into smaller-size trades, factoring in such as transaction costs, market impact and other criteria. "What's new about algorithmic trading going beyond VWAP (volume weighted average price), (is) it's constantly scanning the markets to effect the best trade with the price with the lowest market impact."

While brokers and buy-side institutions use algorithmic trading to break large orders into smaller chunks to avoid moving the market, traditional block trading is another story. "It's a lot harder to get block trades done," says Hegarty, but he notes that LiquidNet, an anonymous buy-side to buy-side block-trading system, is gaining serious traction. LiquidNet was executing five to six million shares at the beginning of 2003, and "it's not uncommon to see it doing 18 to 20 million shares a day," he notes. "Head traders are gradually becoming more comfortable with the anonymous block model," says Hegarty. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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