A former block trading executive is hoping to replicate the action in the upstairs market electronically.
Kevin Callahan, until 2009 a marketing official with upstairs shop JonesTrading, has formed Ax Trading to launch an electronic call auction. The alternative trading system lets buyside traders auction off their own orders automatically, much as an upstairs sales trader might do telephonically.
Callahan says the process is cheaper and more efficient than using an upstairs desk. "I would argue that the entire upstairs market really runs on a call market model," Callahan said. "Nobody has done this before."
Bob Schwartz, a finance professor at Baruch College’s Zicklin School of Business, an adviser to Ax, and an expert on call auctions agrees. "This is a great development," Schwartz said. "Ax Trading is an innovation in market structure."
Callahan, Ax’s chief executive, was inspired to launch the company after reading Schwartz’s book "The Electronic Call Auction: Market Mechanism and Trading: Building a Better Stock Market." Schwartz introduced Callahan to Peter Jenkins, a former buyside trader and NYSE Euronext executive, and the two men formed a partnership in 2009. Ax recently hired Jim Ross, a longtime champion of call auctions, who built systems for several agency brokerages.
A few of the exchanges run call auctions-both electronic and manual-at the opening and close. A couple of brokers have introduced electronic call auctions for entire portfolios in recent years, but failed to gain traction.
But the last time anyone tried to operate an electronic call auction for individual stocks was in 2001 when the 11-year-old Arizona Stock Exchange shut down. The system’s demise followed that of OptiMark, another call market for stocks, in 2000.
Ax differs from these systems in at least three crucial ways. First, it operates during market hours; AZX was only permitted to operate after hours. Second, Ax does not operate on a fixed schedule. Traders can initiate an auction whenever they choose. Optimark and AZX auctions went off at set times during the day. Third, only limited information about an order is revealed to a potential counterparty. AZX, by contrast, was an open book.
Ax is geared toward trades of small capitalization stocks that may be difficult to get done in the public markets. To initiate an auction, a trader transmits a firm-and priced-order of at least 25,000 shares. Most orders are expected to be "blind" where the initiator only discloses symbol and size. He does not reveal whether he is a buyer or seller. Nor does he reveal his price.
The order triggers a series of email blasts to traders who have previously expressed interest in participating in auctions. Those traders then transmit their own orders. The entire process takes five minutes. Trades that get done occur at a price that clears the market.
The process effectively automates the telephoning work of an upstairs trader. In the upstairs market, a buysider will call his coverage and ask the sales trader to locate the other side of the trade. The sales trader will then spend several minutes or hours calling around for the contra-side. The final trade may involve several parties.
"It can be a very inefficient process," Callahan said. "We are trying to create a central clearing house for both the buyside and the sellside that is all electronic."
In the world of alternative trading systems, Ax is not radically different from the pack. Like most dark pools, orders are paired up in an anonymous system outside of the public markets. There are now about three dozen of these ATSs operated by brokerages.
Most dark pools, however, are continuous crosses. Traders post orders in the systems or ‘ping’ them in hopes of finding a match. A few such as Liquidnet and Pipeline are similar to Ax in that they are messaging systems. Once the system is informed of an order it sends out messages to other traders inviting them to trade.
Callahan explains that a crucial difference between Ax and all the other dark pools is in the execution. The call auction can involve several buyers and sellers and produces a price. Most dark pool trades are bilateral affairs-one buyer and one seller-and are priced at the midpoint of the national best bid and offer.
"We don’t just find the first seller and plug at the midpoint," the exec said.
Schwartz explains that multi-lateral trades are good for the marketplace as they produce better prices. "It’s in the best interest of the marketplace to have more participants producing a single price."
Schwartz, a longtime proponent of call auctions, acknowledges though that, to be successful, Ax needs to achieve critical mass. That may be tough in the current market. At least one buyside trader that spoke with Traders Magazine, said he was familiar with the system but didn’t have enough order flow to try it out.
His complaint is familiar. Volume has been depressed for two years as Americans, gun-shy following the last crash, shun equities. Data from the Investment Company Institute shows that investors took more money out of equity mutual funds last year than they put in.
If a desk does have flow to spread around, Ax likely has the name of the head trader. The company maintains a database of 5,000 buysiders and their emails (purchased from BigDough) and has gotten interest from about 1,000, according to Callahan.
The tiny agency brokerage has also landed a giant partner. It entered into a distribution agreement with Credit Suisse’s Advanced Execution Services that makes connectivity to the start-up very easy. Any trader with access to AES algorithms will now find a new button on their consoles that lets them route orders to Ax. Credit Suisse is regarded as the Number One electronic trading house, with hundreds of customers on both the buyside and the sellside. The two companies have a revenue sharing agreement, Callahan explained.
"This is a critical mass type business," Callahan said. "If someone calls an auction and nobody comes, it’s like a tree that falls in the forest. So we knew we wanted to have a distribution partner, someone who is already on everyone’s desktop."
Ax has conducted auctions in 60 different stocks since the system was switched on in December, according to Callahan. It has had six successful auctions. The average market capitalization of the stocks has been $2 billion. The roster includes several micro-caps as well as a few mid-caps. The average order size has been 155,000 shares. The average trade size has been 108,000 shares.
