There was a tidal wave of trading near the end of 2008, but not for the industry’s electronic crossing networks.
In September and October of last year, share volume hit records highs. But the surge of trading during those months did not lift all boats: Electronic crossing systems actually saw a decline in volume. This is because extreme volatility daunted many buyside traders from using them to execute as many blocks.
The impulse traders have when the market gets volatile has been to get the trade done as quickly as possible, says Justin Schack, a market structure analyst at Rosenblatt Securities. This would mean using algorithms, heading to the displayed markets and avoiding the types of big block-crossing networks that they might consider during a calmer period, he adds.
“In a really fast-moving market,” Schack says, “you don’t want to be out there in a dark pool hoping that you’re going to find a natural counterparty for a really big trade because the market could swing against you while you wait.”
Traditional block-trading dark pools offered by Liquidnet, Pipeline Trading Systems and Investment Technology Group saw their market share for those two months drop 39 percent, compared with their average during the previous eight-month period, January through August. Liquidnet, Pipeline and ITG collectively averaged 0.67 percent of overall market volume in September and October, against 1.1 percent they averaged from January through August, according to dark pool volume estimates the consultancy TABB Group supplied Traders Magazine.
Volume Swells
Collectively, their volume dropped 6.5 percent to 70.8 million shares per day, single-counted, in September and October. This compared with the 75.7 million shares a day, single-counted, they traded the prior eight months, TABB data showed.
Overall market volume from January through August averaged about 6.9 billion shares a day, says TABB. But September and October’s combined average daily volume grew to 10.5 billion shares-or nearly 53 percent over the first eight months of the year’s average daily volume.
The TABB numbers include the top 14 dark pools-broker and agency-and do not include unreported dark volume.
The problem was volatility-and its impact on liquidity-says Laurie Berke, a senior consultant with the TABB Group, and author of a recent report on institutional trading.
Volatility, or the rapid and extreme fluctuation in stock prices, originates from uncertainty, and a disappearance of buyers or sellers. Conditions are generally considered volatile when the Chicago Board Options Exchange’s volatility index-or VIX-measures at least 25.
All About the Volatility
By May, last year was shaping into one of the most volatile years since the Great Depression. The VIX was clearing 25 routinely, after having mostly averaged in the teens since 2004.
But in mid-September, the VIX catapulted skyward and eventually crossed the 80 mark. It averaged 30.2 in September and 61.2 for October. And along with volatility comes a fear of committing too many shares at a moment in time at one price.
“If I’m a buyside trader with an opportunity to put up a block right now in a market that could have my stock moving either way to my benefit, or moving away from me by 50 to 100 basis points in the next half-hour,” Berke says, “I’m going to be somewhat reluctant to do that.”
Buyside traders said as much in the interviews that comprised Berke’s report-in which 61 long-only, institutional asset management firms with almost $13 trillion collectively under management participated. They described to her how their reluctance to print a big block of stock amid the extreme volatility caused them to back away from allocating a percentage of their order flow to the block-trading pools.
Instead, traders might opt for strategies that bring a degree of certainty, says Jennifer Setzenfand, a senior trader with Pittsburgh-based Federated Advisory Services Company. Thus, she says, one might spread an order that is 20 percent of a name’s daily volume throughout a volatile day using a standard VWAP algorithm.
Or, another buyside trader adds, he could be using a combination: working part of an order with an algo, and exposing the rest to Liquidnet.
But the major problem during these volatile times, confides another buyside trader, is that buyers or sellers are too often on the same side: When the market falls, buyers “go on strike.” The same applies for upward swings, he adds: Sellers disappear. He says dark pool aggregators have increased their business at the expense of the block systems.
According to the TABB report’s findings, the percentage of daily share volume a buyside trader executed in blocks of 10,000 shares or more dropped to 12 percent in 2008, from an “already weak” 16 percent in 2007. For its part, TABB started its survey right before Lehman Brothers’ collapse, and finished just as Citi and Wells Fargo battled over Wachovia.
For the Defense
Operators of the three crossing systems said the aggregate numbers don’t tell the whole story.
Pipeline saw some record volume days in its block market in October, in the very heart of the volatility, says its chairman, Alfred Berkeley. About 85 percent of Pipeline’s volume consists of execution sizes that average around 50,000 shares.
Liquidnet said its number of prints above 1 million shares more than doubled in September and October from the previous eight months. The firm averaged almost 50 such prints during the two months, including a Liquidnet record 59 in September, says Vlad Khandros, with the firm’s corporate strategy group. From January through August, Liquidnet averaged about 24 prints of more than one million shares.
Buyside Use
Despite the TABB report’s interview findings, buyside traders who spoke to Traders Magazine say they continued to use the block-trading crossing engines during the volatility. For Federated Advisory’s Setzenfand, the block-crossing networks work with her directional call approach.
If she feels the market and the sector are trending downward and she has a sell order, she’ll put it in every dark pool she can to get the fastest liquidity to get it done. Conversely, Setzenfand says, if she thinks the direction is down and she has a buy, she’ll likely give the order to a broker to “work slowly and pick her spots on.”
“In a downward-trending market, with most of the sells over the past couple of months, your first print has probably been your best print,” she says. “So, if I get something in Liquidnet, I’m going to hit that for as much size as I can.”
At small-cap specialists Lee Munder Capital Group, in Boston, head trader John Despotopulos says price is important. But liquidity needs can sometimes trump price needs, he adds, when he wants to get a large block done within a certain price range.
He appreciates the flexibility one block-crossing firm gives him that the broker dark pools don’t. When a match comes in for a block on Liquidnet, Despotopulos can decide to back out of the trade if the market gyrates suddenly and moves against him, or he can go through with it if it’s moving in his favor.
“You could put a limit in [the broker dark pools],” he says. “But with the volatility, it could move up and back and you might get run over in a venue like that. With the Liquidnets of the world-or the larger ones-you have a bit more control. There’s a negotiation that goes on there, and you can decide if you want to do the trade right then and there.”
Tremendous Value
The future looks strong for the traditional crossing networks, though. Over time, the block-crossing networks will continue to benefit from two things, TABB’s Berke says.
First, there is tremendous value in being able to find block liquidity, she says. Second, because block liquidity is valuable and harder to find, the networks have some pricing power that the algorithms lack.
“If we look at commission rates,” Berke says, “crossing networks have suffered less pressure on commission rates than algorithms, because there’s some significant value there.”
Berke added that flow should return to the crossing networks once volatility calms down. And going forward, traders say they will continue to use the crossing networks for blocks when it does.
“If you have an order on the desk and you need to find liquidity, you’re going to go wherever the liquidity is,” Despotopulos says. “As far as blocks go, [block-crossing networks] tend to be the place to get the larger volume done. You’re not going to find that through your traditional broker as much anymore.”
Pool Volume Rising
Overall, dark pools averaged 7.6 percent of total equities volume in September and October, according to TABB figures. That compared with the 8.3 percent they averaged from January through August.
Total dark pool volume grew 39.2 percent between the two periods, TABB figures showed. They averaged 795 million shares a day in September and October, up from averaging 571 million shares a day from January through August.
But the dark pool volume increase did not keep pace with the boom in total volume. “What we’ve seen is when the VIX went from 20-to-30 up to 50-to-70, the whole group of dark pools suffered as a result,” says Justin Schack, market structure analyst at Rosenblatt Securities. “But the block-oriented pools probably suffered a bit more.”
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