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New Block Trading System To Prevent Information Leakage

A new electronic-trading system being tested by brokers and institutions claims it can prevent front running.

At a time when there is concern over front running and conflicts of interest with stock-exchange specialists, the scientific method is rearing its head.

A former researcher at Los Alamos National Laboratory, with a doctorate in nuclear particle physics, says he's found a solution to the block-trading problem.

"In my system, there is no potential for pre-trade information leakage," says Fred Federspiel, chief executive officer (CEO) of Pipeline Trading Systems, based in New York City. Federspiel plans to launch Pipeline as an alternative-trading system (ATS) for trading large blocks of stocks listed on the New York Stock Exchange and Nasdaq. It will also include exchange traded funds (ETFs). Because Pipeline's order book is hidden and natural buyers and sellers find each other anonymously, Federspiel contends it avoids the problems of front-running and penny jumping. Federspiel will unveil the system at the STA (Securities Traders Association) conference this week in Scottsdale, Arizona. Unlike other electronic block-matching systems such as LiquidNet, which is restricted to buy-side institutions, Pipeline is designed to bring together the entire trading community, says Federspiel. "There is no system out there that permits the entire trading community to bring its liquidity to one marketplace and allows all serious traders - whether they are traders at broker/dealers, institutions or hedge funds - to try to get their blocks executed," contends Federspiel.

Taking a scientific approach to encourage interaction among traders, Pipeline generates a pre-analytic calculation called a block price range or BPR for each stock symbol, which sets a range for determining when an order is reasonably priced. "The BPR is a key piece of technology that's based on a real-time measurement of the stocks recent volatility," explains Federspiel.

This calculation is based on public quotes and looks at every trade printed in a stock, including small, 100-share type orders, he says. Whenever the hidden book contains an order that is within this BPR and satisfies the minimum size requirements - 25,000 shares for most stocks and 100,000 shares for top stocks by average-daily-volume - then Pipeline disseminates what it calls a Pipeline Firm Interest (PFI) to all of its subscribers for that symbol. If the symbol is GE for General Electric, then every trader who has GE on their watch list and is interested in subscribing to GE, would get information that there is a serious order from the PFI, he explains.

GE would turn orange on their Pipeline ticker, indicating there's a seriously priced order for GE. "When a trader sees the PFI, he or she can place another order into the hidden book to see if it crosses with that order," says Federspiel. "Because it's a hidden book, you've not tipped anyone else that you are a buyer and you prevent penny jumping," he adds.

Federspiel contends that other systems reveal whether the order is a buy or sell and often force one side to walk away from the other. "If you view a PFI, if you click on it and send it an order, you leak no information. The other party has no chance to back away. That order is going to be automatically executed with the hidden book."

Participants can enter either standard limit orders or limit orders that are pegged to the midpoint of the national best bid and offer (NBBO), which Fiederspiel says is the basis for competing systems such as ITG Posit and some electronic communications networks (ECNs).

Right now Pipeline is in alpha testing with over a dozen of institutional investors and brokerages, and is being offered to other firms interested in participating in the beta test, according to the company. The system is currently being registered as a broker/dealer with the NASD which is necessary before it can to the Securities and Exchange Commission (SEC) for ATS status. Federspiel expects the regulatory process to take until the end of the first quarter, with full deployment of the system occurring early in the second quarter of 2004.

Federspiel has been working on the institutional block-trading problem for the past four years. After rising to senior scientist at Los Alamos, he left after seven years and joined The Bios Group, a technical consulting company founded by Ernst & Young, where he sold projects into financial services companies. In 1999, he founded Exchange Advantage to go after the problem. Pipeline is a direct outgrowth of that work. "It's fortuitous timing. When people are crying out for alternatives, and we have one," he says. 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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