Competition can be so cutthroat on Wall Street that it takes an especially big threat for rivals to band together. Such is the case in institutional stock brokerage. Mutual funds and other big investors increasingly are diverting orders to electronic networks that promise to more efficiently execute block trades. In response, six of the industry’s biggest brokerage houses — Citigroup; Goldman, Sachs & Co.; Lehman Brothers; Merrill Lynch & Co; Morgan Stanley and UBS — announced in September that they would form the Block Interest Discovery Service, a utility designed to mimic the features of upstart trading systems.
Clients have been seeking alternatives to traditional block-trading desks because of regulatory and technological changes that have made it more difficult to move big quantities of shares. The decimalization of stock prices in 2001, for instance, caused quotes to fluctuate more frequently, encouraging smaller trades. The average New York Stock Exchange transaction is now less than 400 shares, down from more than 1,000 five years ago. Entrepreneurs are exploiting new technology to launch innovative electronic trading networks; there are now more than 30 markets where U.S. equities are traded.
“There is a lot of fragmentation,” says Kirk Allen, senior vice president of trading at Los Angeles–based NWQ Investment Management Co., a subsidiary of big money manager Nuveen Investments. “The reality is, it’s more challenging to trade a large block.”
Brokerages have responded by adopting technology that breaks big orders apart and routes the pieces to be executed wherever the best prices are quoted. But institutions still long for the ability to buy or sell a big block in one transaction at a single price. That desire is fueling the popularity of crossing networks like Liquidnet, Pipeline Trading Systems and Investment Technology Group’s Posit, which allow investors to trade with one another off-exchange. Launched in 2002, Liquidnet now executes about 56 million shares a day. Pipeline, just two years young, handles 30 million.
For Wall Street brokerages, this loss of order flow comes at a time when commission rates are shrinking, making it more important than ever to execute a high volume of trades. That’s where BIDS comes into play. Essentially, it is the Street’s attempt to retain orders that otherwise would go to rival crossing networks. Institutions can access the network, set to launch early next year, through any of the six sponsoring brokerages. Clients enter the desired price and size of their transaction — there is no minimum — and the system will search for a corresponding order. When it finds a match, BIDS automatically executes the trade.
If no match is available, an institution can still negotiate a transaction with another user. Say one fund is willing to buy a stock for $41 per share and another is willing to sell at $41.05. The system will alert both traders about the opportunity to negotiate anonymously, and provide an electronic forum in which to do so. As a safeguard against exploiting this feature solely to gain knowledge of rivals’ intentions, BIDS plans to monitor and rate users. Traders who constantly enter negotiations for a glimpse of what others are doing but fail to consummate transactions may see their scores suffer and be spurned by other users as a result.
By banding together, the six firms behind BIDS hope to create a deeper pool of users and orders than any one firm could create on its own. In addition, these sponsoring brokerages, as well as other sell-side firms, can put orders into the system, a feature that distinguishes the network from buy-side-only platforms like Liquidnet and Posit.
“The more participants you have multiplies the amount of crossing you can get,” explains Lawrence Leibowitz, chief operating officer for U.S. equities at UBS.
Although BIDS itself is not for profit, it is very much an attempt by the six firms to boost the profitability of equity trading. They will collect commissions on trades executed in the system — though none will say how much it plans to charge, most crossing networks bill at 1 or 2 cents per share — and institutions will be able to use those commissions as so-called soft dollars, to pay for research and other nonexecution services that the brokerages provide.
“The buy side does not want to throw the current market structure away,” says Paul Hanson, a director of Alberta Market Solutions, the Calgary-based trading technology company that is building the BIDS system. He predicts that BIDS will trade 50 million shares a day by 2008, adding, “They want refinement of the model built around cooperation.”
