A traditional block, defined as 10,000 shares or more, is just a drop in the bucket. Firms such as Liquidnet and Pipeline Trading Systems are redefining the block trading market and facilitating its expansion globally.

In the US, most individual investors access the financial markets through their pension plan, 401(k) or mutual fund. Large financial intermediaries serve as their trustees and manage huge pools of money. Once these fund managers decide to buy or sell a stock to reposition their portfolio, they need to be able to trade in size. But the market structure has changed in such a way that it is difficult to execute large trade orders. The proliferation of retail and algorithmic trading and recent government regulations have driven the average execution size on US exchanges from more than 2,000 shares down to about 340 shares. Moreover, decimalization has led to a 70 percent decline in what stock is available at any given price point on the exchanges.

“There is a huge disparity between the size of institutional orders [and] the amount of stock that is available for purchase on the exchange,” says Seth Merrin, CEO of Liquidnet in New York. “To avoid adversely moving the share price, institutions have to chop up their orders into tiny pieces to make it look like they are retail.”

Alfred Berkeley, chairman of Pipeline Trading Systems, agrees. “No large investor wants to say to the public, ‘I
want to sell a million shares of Ford Motor’ because they will get crucified. The price will change simply because they showed their hand.”

Given this scenario, the block market almost vanished until some pioneers in electronic trading came up with a formula to meet large investors’ needs. Five years ago, Liquidnet set up an electronic marketplace that allows institutions to trade large blocks of equities directly and anonymously with significant price improvement and little or no market impact.

Before Pipeline set up its Alternative Trading System in 2003, it asked asset managers how big the blocks should be. Their response: in very liquid stocks – those that trade more than five million shares a day on average – the minimum block size should be 100,000 shares. For illiquid stocks that trade fewer than 500,000 shares a day, the minimum should be 10,000 shares, and everything in between should be 25,000.

“We just listened to the customer and said, ‘OK, that’s what we’re going to establish as our minimum block,’” says Berkeley. “We have a floating minimum block size, depending on the liquidity of the stock.”

Pipeline also hides information useful to predators, so it is impossible to tell exactly how many shares sellers are offering or at what price they are willing to trade. Even Pipeline’s salespeople do not know the size of customer orders.

THIS PHENOMENON is emerging in other parts of the world as well, as evidenced by Liquidnet’s growth in Europe during the first quarter of 2006, which was up 43 percent over the fourth quarter of 2005. The firm is now planning to expand to Asia in the next year or so, targeting markets such as Japan, Hong Kong, Malaysia, Singapore, Australia and New Zealand.

In Europe, an institutional execution on Liquidnet is currently around 1.35 million euros, compared with an average execution size of around 40,000 euros on the local exchanges. In the UK, Liquidnet’s principal trade
size is, on average, 20 times larger than on the LSE.

What constitutes a block trade depends on the type of stock being traded and the percentage of a day’s volume of that stock that investors want to trade. “If you’re looking at Vodafone or Ericsson, which trade many millions of shares daily, a block could be half a million or a million shares,” says John Barker, Managing Director of Liquidnet Europe. “But when you get smaller and more thinly traded stocks, it’s fair to say a block might be as little as 25,000 to 50,000 shares.”

US and European exchanges trade an enormous number of blocks daily. But, as the average execution size continues to decline, it is becoming more difficult to provide liquidity in the size institutions are demanding. To deal with this issue, Nasdaq in the US is trying to restore institutional size liquidity by introducing an intraday cross. A couple of times a day, exchange members aggregate their orders and execute as many deals as
possible.

And several exchanges offer “icebergs.” These allow institutions to put a block of, say, one million shares onto
the order book but only show clips of 20,000. But as Barker points out, when a broker lifts the first 20,000 shares, and then immediately reloads with another 20,000, it is obvious that there is size behind the order.

“The challenge lies in coming up with a way to do this without having to give too much information away,” he says. “I think the exchanges are getting partly there, but they’ve got some way to go.”

Drivers behind block trading

* Growth in assets under management
* Reduced average execution size on US exchanges
* Need for liquidity in large size trades

»We have a floating minimum block size, depending on the liquidity of the stock.« Alfred Berkeley, chairman of Pipeline Trading Systems

»To avoid adversely moving the share price, institutions have to chop up their orders into tiny pieces to make it look like they are retail.« Seth Merrin, CEO of Liquidnet

»...a block could be half a million or a million shares. But ...a block might be as little as 25,000 to 50,000 shares.« John Barker, Managing Director of Liquidnet Europe