US Equity Market Structure: Stumbling Blocks

The buy side continues to value block trading as it did a decade ago and yet the block percentage of overall volume has dropped significantly in the wake of the market structure changes of 2001-2007. New solutions adjusting to a post-Reg NMS environment have enabled block trading volumes to stabilize, yet there is a significant gap between what could trade as a block, the amount the buy side wants to trade in blocks and the actual block numbers.

Cracking the block market is a tall order and there is little question that the last decade has seen many attempts to solve for it. In order to facilitate block trading, a solution needs to try and solve for multiple requirements which are often at odds with one another, including enabling trusted counterparties and allowing for anonymity, sourcing liquidity and paying for services, quick matching engines and seamless workflow integration, and finally marrying electronic messaging with traditional sales trading.

Even within ring-fenced communities or with a trusted counterparty, the buy side has learned that it pays to be paranoid. The outstanding trust issues lead some traders to prefer to rein in their exposure to certain types of venues (limiting exposure to liquidity) and other traders to use all of them (limiting order size). Market macroeconomics also plays a role in the ability of traders to bring block-sized orders together. There is a dynamic and complex combination of factors that go into block trading volumes that cannot be viewed in a vacuum.

In addition to trust and seeking liquidity, buy side firms must wrestle with the challenge of funding (via commissions) specific relationships for broader brokerage services. Thus, any attempt to increase block trading from its current levels has a better chance if it works within the traditional buy side and sell side sales and trading arrangements. The culmination of these reasons results in the dispersion of methods in executing block-sized order flow.

There is no technological panacea that will make trading more trustworthy. However, there are mechanisms that offer better protection to the buy side that will increase the number of interactions the buy side would have with its trusted counterparties. While early successes have been shown to have a ceiling in the amount of block liquidity that can be brought under the roof of an independent venue, it is hard to imagine what buy side traders would have done without them. New innovative solutions, not targeted regulation, will need to address the business model tensions and market complexities.