although perhaps not in the U.K. where there is still a dealer culturerather than an electronic order book culture. I would say that this is a marketstructure problem in New York. Price formation has just too littletransparency. I would love to hear the buy-side firms respond to that.SCHWARTZ: Or the sell-side.TIEFENBRUN [From the Floor]: Either or.BROOKS: We are dodging something in this part of this discussion –price. Every day we have, say, GE, and its fundamentals might change – atglacial speed, I grant you. Yet intra-day GE’s volatility is 5%. Knowingthis, do I want to have completed my 100,000-share order at 9:37? I hadbetter have a pretty strong feeling to do so. I am sure Chris would say thesame thing. Actually, so would everyone on the panel.We are keeping our cards close because we are wondering about thelegitimacy of the prices that we see. It is not because of the specialist oranybody else. It is just the way the markets are. Everybody at the table, asthe options guys were describing, seem to make a lot of money from intraday volatility. I think that runs counter to long-term investing. I am notsaying that one is better than the other, but intra-day volatility is a very scarything for long-term oriented investors.SCHWARTZ: I am not sure that the options people on the previouspanel were saying that the accentuated intra-day volatility is good.BROOKS: I think that is how they make their money.SCHWARTZ: I don’t know. I was going to ask David Krell one morequestion, but we were running late. I will ask it now. David, if you acceptthat the first half-hour and the open-to-close volatilities are accentuated, thatthe accentuation is related to trading costs, and that we could mute theaccentuation with better market structure, what effect would this have onoption prices? What would your answer be?DAVID KRELL36 [From the Floor]: From an option trader’s viewpoint,the accentuated volatility hurts the options markets because the layoff on the
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stock, which is what the hedge is, costs you more money. As a result, youhave to build that into the price of the option. I think that higher gradualvolatility is probably helpful. But accentuated, short-term volatility (intraday volatility) is probably negative.SCHWARTZ: As we talk about accentuated volatility in the first halfhour (or from open-to-close, if you wish), is it reasonable that theaccentuation is a reflection of market quality? Is it reasonable to expect, ifwe had improved market structures, that we would see less of this volatilityaccentuation? George, I would like to hear what you have to say.GEORGE SOFIANOS: I would first like to introduce a new concept thatI think is very useful when we talk about large orders. When we talk aboutvery large orders, it is important to distinguish between volatility and what Ilike to call ‘stock momentum.’ Volatility is essentially price fluctuationsaround the trend. What I call ‘stock momentum’ is the change in the stock’sprice over the horizon of a trade. We are talking about a large trade that mayactually take several hours or several days to complete. Looked at in thiscontext, intra-day volatility around the trend is a very small component ofthe trading cost.The biggest component of the trading cost (I think Andy alluded to it) ismomentum, the direction of the market. If you are buying, and the market isrising, and you are slow, you get killed. If you look at the numbers and tryto decompose them for the volatility and the momentum, you will find that,for the very large orders that take time, momentum is everything. This isvery important.I have a controversial statement that I will make to generate discussion.For very large orders, for orders that are multiples of average daily tradingvolume, market structure does not matter. Momentum, as opposed to intraday volatility, is not so sensitive to market structure. For these very largeorders, what you want to tap is the non-displayed liquidity on the buy-side.There is no system out there, no market structure that would make the buyside reveal its non-displayed liquidity. Those very large orders are beyondthe realm of market structure.SCHWARTZ: I agree with a lot of what you said. Momentum is a bigcost. But I also wonder where the momentum comes from? Is it because ofa butterfly that flapped its wings in Mexico? Is its genesis in the operationsof the retail market? Is it the result of larger orders that are broken up?When a large order is broken up, the trader is bringing similarly signedpieces – buy, buy, buy, or sell, sell, sell – to the market, over a period oftime. Does that become a foundation for momentum? Yes, or no? Bruce?
36
David Krell is President and CEO of the International Securities Exchange.
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BRUCE TURNER: Absolutely. You cannot keep feeding orders in andnot expect them to impact what is going on. I mean, you have an order thatis 100% of average daily volume, and you keep dropping in 50 thousandshares at a time, you are telegraphing what you are doing.SCHWARTZ: We are, of course, in an academic environment. We areon thefloor of a business school that teaches finance courses, and thatgets into issues such as capital markets efficiency. What is the standardthing we keep hearing from academia? The classic concept of an efficientmarket is one where prices follow a random walk. Now here we are, talkingabout momentum. Momentum is not random walk.I ask my class, how many of you believe in random walk? Boy, are theyquiet. Nobody raises his or her hands. I would not raise mine either. Howmany of you here believe in random walk? No hands being raised? I am notsurprised. People who believe in random walk usually do not walk intoconferences of this nature.I am dwelling on this a bit because momentum trading is in conflict withrandom walk and hence market efficiency. I would like to know more abouthow momentum might relate to psychology, especially the psychology of theretail customer. But there is something more tangible involved. There is theslicing and dicing of the institutional sized orders.If what I just said is correct, doesn’t it imply that market structure doesmatter? Doesn’t market structure matter if momentum starts withinstitutions having to slice and dice their orders and work them over a periodof time in order to get to the liquidity pools?MADOFF: Are you assuming that a liquidity pool is there on the otherside?SCHWARTZ: Perhaps. But, where is the liquidity pool on the otherside? We talk a lot about connecting with liquidity pools on the other side.Are they there?MADOFF: It depends on the genesis of an institutional order. The wayin which information is disseminated now, it goes to everybody, and it doesso quickly. What has triggered the institutional order? Why is the investor abuyer of stock? Today, the individual who is buying 200 shares of a stock isreading a research report, in all probability on the Internet, and he or shemay have the same reason to buy that Andy has. And now Andy’s horserace has a lot more players in it than it used to. Before it meant about teninstitutions doing the same thing. Now you may have 10 large institutionsand 50 small institutions all of which may, for some reason, have an ordersimilar to Andy’s. Plus, you may also have a host of individual investors, allwith similar market access. Now, suddenly, everybody has direct access, orsome direct access like product.
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SCHWARTZ: There is a term I first heard in London a decade or so agowhen I was over there doing some work with Anthony Neuberger. Anthonyreferred quite a bit to ‘one-sided markets.’ I remember our discussions ofinstitutions getting similar research reports. This leads to a situation where,when one wants to buy, chances are they all want to buy. When one wantsto sell, they all want to sell. Today in theU.S., with more players and morediversity, are one-sided markets more prevalent or less?BROOKS: The answer is, everything is for sale at a price. Everythingcan be bought at a price. We are back to the basic challenges that we face –price versus volume, immediacy versus patience, and perfect knowledgeversus the random walk. That is the finesse part, the art form that is nowmore of a challenge because of the number of players that people reference.There are so many more players today in the horse race. Outcomes are notso clear. Yes, we think the stock is cheap and we want to buy it. Theremight be a natural on the other side size. On the other hand, a decision tobuy or to sell could be driven by a stock valuation and not by the naturalsupply and demand of stock. We may want to initiate a sell order, forexample, because the stock is fully valued, or we may initiate a purchasebecause we found out from doing our fundamental analysis that a newproduct offering is being well received. Most of the time, we are acting onour fundamental analysis and portfolio decisions. We may want moreexposure to healthcare, for example if it looks cheap.SCHWARTZ: What is your view of it Barry?SMALL: Andy makes a good point about price. But there is a lot ofactivity between what you want the price to be and what you expect the priceto be. The role of the intermediary is still important. A big investor likeAndy needs a buffer. He needs to find capital to bridge himself from thatexpectation of price to what is reality. It could be something as simple as,every value trader wants to get out. If so, the value guy could be the naturalother side of Andy’s trade, but he doesn’t want to be the first one in. Sothere is going to be a lot of intermediary plays in there. Maybe hedge fundscome in and bottom fish. There may be market makers. It might be meputting up significant capital for Andy. I could wind up taking on a positionand holding it for a period of time. Eventually, price will get to a levelwhere a value trader will stand up and put his bid in, and he will be thenatural other side of the trade. Still, the natural other side is elusive. Even ifwe get a wonderful new system like Seth Merrin’s Liquidnet, and Seth getsnice volume on it, there are still not a lot of transactions.SCHWARTZ: Seth is the person to ask. You are looking for the naturalother side, aren’t you, Seth? When Andy wants to sell, is it more likely thatChris wants to sell also? How common are one-sided markets? Or, Seth, doyou find that there are natural counterparts.
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SETH MERRIN37 [From the Floor]:There are always naturalcounterparts. Obviously, lots of institutions are always on the same side inour market. But, as more and more institutions come on board, we achieve ahigher match rate. When Liquidnet started out, we had a very small matchpercentage. Now we are showing liquidity in about 20% of all of the ordersthat people have on their desks throughout our entire community. There arematches, but only about 20%. You could also say, wow, it is amazing! I canget 20% of my orders done through Liquidnet right now!SCHWARTZ: If you would allow me, I would say ‘wow.’ Whatever itis that allows somebody who wants to do a job, to find the liquidity on theother side, is pretty good. If something could be improved by superiormarket structure, if a structural change could enable buyers and sellers tofind each other at a price without having to take seven days, or five days, orone to fill an order, I would say that that would be a better quality market.TURNER: We are talking about how to get as much information outthere as we can. Let’s face it, we are all playing poker. We have already gotabout eighteen analogies out there, so I will try not to add to them (laughter).But we are all playing poker, and we all keep our cards close to our chests.So the question is, how do we make people feel more comfortable aboutwhat is out there?The liquidity pools do matter. They are diverse, and there are multipleliquidity pools out there. How can we aggregate them in one spot?Aggregating them would impact on the whole process. As you start to feelmore comfortable about putting 3,000 out there, it will be more comfortablefor some other person to put 5,000 out there on the other side. Once there ismore liquidity in a stock you will feel more comfortable about putting upsize because the price is less likely to run away from you. It becomes thegame that I think Seth was talking about.SCHWARTZ: That certainly is the point that I was trying to make.There are people at opposite sides. I do not mean to imply that it will everbe perfect. If you are going to trade that large number of shares, you have toaccept that you cannot do it instantaneously. The critical question is, could‘finding the other side’ be done better and faster than we are currently doingit? That is where the issues of market structure and market quality intersect.HOLLY STARK38 [From the Floor]: The problem is exacerbated whenyou move down the capitalization levels. Those pools of liquidity are notponds. They are little droplets. Let’s stay with the water analogy now, as37
Seth Merrin is CEO of Liquidnet.
38
Holly Stark is Principal and Director of Trading at Kern Capital Management.
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opposed to horses. Your market impact will be much greater as you try totrade an outsized piece of stock. If, as was mentioned, you take a stock tothe level where it is going to trade, you will certainly have market impact. Itwould be much more efficient, especially with those stocks that are highlyilliquid, and where there might not be an institution on the other side of thetrade, to have another approach. There may be ten institutional holders andthe liquidity droplets may be in the retail marketplace. You would havebetter price discovery and a more efficient market, if you had a call market –especially for those less liquid shares. You didn’t pay me to say this, Bob(laughter).SCHWARTZ: No, but I will (laughter).STARK [From the Floor]: Truly, there are many more inefficiencies inthe small cap market, and your price impact can be so much greater.Especially if you have an outsized order.TURNER: But Holly, suppose that you want to buy 5% of the dailyvolume of a stock in a call auction. And you get this call auction at, say, 10:00 a.m., and everybody submits his or her orders. The liquidity to get yourorder done may climb to 20% of the then current total volume. So you get itdone in one block in the call, but with volume in the stock having increasedby quite some percentage points. George is calling it momentum, and youare calling it a call. Whichever, the net result is that you still pay a price ifyou agreed to buy at the price set in the call. But, as Andy said, there isalways a buyer and a seller.STARK [From the Floor]: Yes, you are pricing the order.BROOKS: And it is a static moment in time.TURNER: Right, and your theory being, we know it is a static point intime, and it may not trade again, and so we all have to be there.STARK [From the Floor]: Yes.TURNER: I do not know how that would work. We need a continuousmarket. And you will never get people to reveal 100% of what they arelooking to do.STARK [From the Floor]: Bruce, I agree with you. That is the buy-sideconundrum. Everyone wants to see the liquidity, but no one is actuallygoing to put his or her order out there. Everyone wants markets to betransparent, but nobody wants anyone else to know what they themselveswant to do. I think someone else mentioned that.But, regardless, call markets and continuous markets are not mutuallyexclusive. Certainly, there will always be people who want to trade on acontinuous basis. Retail people, for instance, who come in whenever theyfire-up their computer. These people want immediacy of execution.Nevertheless, knowing that you might have a better chance of getting a
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certain amount of liquidity done at certain points in time during the daycould be very interesting.TURNER: But it does not solve the slice and dice problem. Whathappens now is that people say, OK, it is time for the POSIT cross. Let’sput apiece in there. Let’s see if we get a hit. If we do, great. If not, we keepgoing.STARK [From the Floor]: Bruce, I do not trade on a VWAP basis. I donot want to get into that.TURNER: No, this is not a VWAP thing. But if you get an oversizedorder on one of these stocks, you want the benefit of having both a call and acontinuous market. The result is that you do not put the whole thing into thecall, because people are still slicing and dicing.SCHWARTZ: There are alternatives other than the call. Liquidnet is analternative in the continuous market. Liquidity Tracker, to an extent, couldbe viewed in this context. Fred, would you say a word about LiquidityTracker?FRED FEDERSPIEL39 [From the Floor]: Liquidity Tracker is a newsystem that will be deployed by Nasdaq this summer.40 As Bruce says, thereis no way you can force any player, buy-side or sell-side, to show his wholehand. But Liquidity Tracker tries to create a system that encourages playersto show a little bit more. For instance, you can select the players to whomyou will show that information based on what they are actually trading inreal time. Liquidity Tracker will be employed by Nasdaq, which hopes itwill encourage the process of showing more size. As I said, you can directthe disclosure to specific parties based on their real-time trading activity.And Liquidity Tracker maintains total anonymity on both sides.SCHWARTZ: Mark Gresack. You have a question?MARK GRESACK41 [From the Floor]: First of all, I want to go onrecord as saying that I like Lead Belly.SCHWARTZ: Oh, good. Can you sing a few bars?GRESACK [From the Floor]: Not really (laughter). My question goesto Andy’s point about price versus volume, and to your issues, Bob, about39
Fred Federspiel is currently CEO of Pipeline Trading Systems.conference, he was CEO of e-Xchange Advantage Corporation.
40
In mid-2003, Nasdaq announced that it was discontinuing Liquidity Tracker, an automatedorder routing system that allowed traders to direct orders to specific market makers.Volume was negligible soon after it was launched.
41
Marc Gresack is currently CEO of Glen Eagle Securities. At the time of the conference, hewas a strategic consultant at Brut LLC.
At the time of the
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market structure. Take Cisco. On a daily basis, Cisco trades 45 or 50million shares a day, sometimes more. Where are all the orders? They areon a reserve book.42 My question is, how has the reserve book changed theway in which the buy-side trades? Does it get to the transparency piece, andto how much you are willing to show? Is it because you do not want toshow your hand all at once and you slice it? The reserve book is a good toolfor doing that. I see on the electronic side that the reserve book has reallychanged the way the buy-side has traded over the last few years.SCHWARTZ: If these new systems – Liquidity Tracker, reserve books,Liquidnet, call auctions, or whatever – change the way that people trade, thequestion is, do they help with the two things that we have discussed: pricediscovery and quantity discovery? If the answer is yes, then that is a bridgebetween market structure and market quality. It is a bridge that I like to talkabout in the context of volatility more than in the context of the bid-askspread.BROOKS: The problem (or the rub) is that the volume discovery doesnot happen because prices are not trusted.SCHWARTZ: Can you speak further about the extent to which you donot trust the prices that you see, and about how that effects your revelationof quantity?BROOKS: It is not just a matter of trusting the price that I see. It is alsomy thoughts about what price might do going forward. If I declare and tradein size – say I trade 750,000 shares of a stock that trades 50,000 share a dayon average – I have gotten the job done, but I have gone way past theaverage daily volume. The question becomes, for me, as an individual withhuman traits and an ego, whether I want to immediately look stupid. Can Irisk that? Am I confident enough in our investment process, in the certaintyof immediately declaring my entire trading interest? Am I confident enoughto immediately risk looking stupid? Hopefully, most of the time I am.SOFIANOS: I guess part of this is due to the continuing trading process.As markets evolve over the trading day, there is more information revealedand the price follows a trend. So you really do not want to put all of youreggs in one basket by having your entire execution done at one point of time.SCHWARTZ: So, Andy, you do have uncertainty about price. I likehow you put it in the context of looking forward.SOFIANOS: But are the fundamentals of the price more a function ofthe market structure? It is this distinction that must be made when volatilityis very sensitive to the momentum over time. This phenomenon only occurswith very large orders. It is not related to market structure. In short time42
A reserve book allows an institution to work portions of a large order without revealingwhat is behind it.
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spans over the course of the trading day the structure of the market will playa much more significant role in the price of a very large order. That’sbecause of the way the order is handled by specialists and others duringthese short periods. Over the long term, these factors play a much lesssignificant role in the price formation.TURNER: Andy’s issue is about putting up an order of 750,000 to buyand then, seeing nothing around it, having the market go against the order.If you have a market structure that allowed you to put that amount of sharesup, a market structure that knows there is some normal line of resistance –that takes into account, for example, a stock that typically trades 50,000shares a day, so it attracts bids and offers in 5,000 and 10,000-share size atparticular prices – then we would have a better solution. This kind ofsystem, for example, would be driven by algorithms that respond to blocktrading in an anonymous environment, a system that would enable buyersand sellers of large blocks to find each other easily. That would respond insome way to Andy’s issue.What happens now is that the print goes up, it is between two players, abuyer and a seller, but someone misses it – a third party who didn’t declare –and all of a sudden they are saying, oh no, I missed it! I got to do something!So they run around trying to see who advertised the trade. They call Andyand Andy does not care. He’s concerned about the market impact the newseller will have, resulting in the slicing behavior traders have adopted. It’sbetter to chase a stock than to be embarrassed on the downside. If we had amarket structure that got all the players together in the first place, that wouldnot happen. The price discovery process, for example, would factor in theseller of 250,000 shares.SCHWARTZ: Barry, you are part of the market structure that helps thatto happen, right?SMALL: Absolutely. My reaction is, with Andy and Bruce’s discomfortcomments, that it is all about limit orders. It is all about the market centersattracting limit orders. Whether it is Nasdaq or the NYSE, we have hugeissues here as to whether that market structure will develop. Will they beable to attract and retain limit orders? If SuperMontage is the answer, and itcan attract limit orders, we are going to have a very good experience. Wewill aggregate the market, and fragmentation will be a much less painfulexperience.We have a big problem at The New York Stock Exchange, however. Thelimit orders are disappearing. There are no limit orders. They haveinstituted a wonderful initiative called the OpenBook43 but there is nothing43
OpenBook is an NYSE product that shows the aggregate limit order volume data for bidsand offers in all Big Board issues.
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there. We have an open book with no book. I am very, very concernedabout the integrity of limit orders coming to the market and being treatedfairly. The NYSE has a major problem there.SuperMontage is on its way to creating a limit order book that will bevery viable. If we all had access to that information, if we all saw that thelimit orders were being treated fairly, our markets would be less volatile.We would make bolder decisions, and everyone would end up with cheapertrading costs.SCHWARTZ: Mark, can you respond from your vantage point to whatBarry just said about limit orders?MADOFF: What Barry just said about limit orders is exactly the case.But the next step in limit order exposure is connecting one market toanother. The key for us is market connectivity. The major flaw that youhave with the New York Stock Exchange is not, in my mind, OpenBook. Ithink OpenBook is a wonderful step in the right direction. The flaw is thelack of automatic execution that enables access to that book. If you addedthat step, then, when you see a quote, you would have access to that quote.Then it becomes a real quote. A quote that you do not have access to is not areal quote. If you have to call a broker, or put an order into a system, andthen someone has to physically run across a room to get to the liquidity, thatis a problem. Even the average turnaround time on a DOT trade issomewhere in excess of 17 seconds. That is a huge issue.You can see an example of this, and realize why automatic execution isimportant, if you look at the growth of the triple Qs. The triple Qs tradeactively in a number of other venues that provide automatic execution. Theyhave taken a huge amount of volume away from the more traditional auctionmarket environments that are not offering automatic execution. The keynow is to go one step further. We must actually connect all of the ECNs andall of the ATSs to a centralized marketplace, similar to the way the ITSsystem operates. An institution wants to look and ask, where is myliquidity? But it is not only where is my liquidity. It is also, how can Iactually access it?An institution should be able to look at a single screen and see an Islandquote, a Redibook quote, an Archipelago quote, and all of the exchangequotes. If it wants to get at one of those pools of liquidity, it should be ableto do so by pushing one button. Something like the concept ofSuperMontage or the ITS, both of which link markets together, could workin practice to solve this problem.4444
Mark Madoff is referring in his remarks on Island ECN (now merged with Instinet), whichis said to ‘trade through’ the markets in executing customer orders. Island, which is not amember of the Intermarket Trading System (ITS), has lobbied for reform of the ITS.
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Today, you must go through any one of a number of private networks toget at that liquidity. And the moment you go into a private network, you runafoul of all sorts of problems. One problem has to do with limit orderdisplay and trade-throughs. Are you really getting the best price? By thetime I send my order into this system, do I actually get the execution? It isnot good for the market, for instance, that one ECN out there will tradeoutside the quotation posted. This same ECN claims its customers knowwhat is happening. Unfortunately, the investors who are hurt are thosewhose orders are traded through by this ECN when it is facilitating its owngroup of customers.You also need a tremendous IT infrastructure to build these networks. Ifyou want liquidity, you have to build the infrastructure. It is very, verydifficult. Getting back to what Barry said, if the limit order display iscritical, you must couple the limit order display with connectivity betweenmarket centers. Then you have solved a huge problem.TURNER: I am a big believer in automatic execution. It makespeople real. There is an issue with that though. By itself, automaticexecution won’t get orders in the book. We must incent people to put ordersin the book, and automatic execution is part of that incentive. However, theonly incentive that will really get people to put orders in the book is the fearthat, if they don’t, they will miss something. That is really what it comesdown to. If you have that fear, people will start putting orders in the book.Then automatic execution will make them all real. Automatic execution is akey component, but we have to go one step beyond automatic execution.Participants must have the fear that they are going to miss something.SCHWARTZ: In other words, you have to be pre-positioned to benefitfrom the incoming event. Is that what you are saying?TURNER: Yes. What we have seen in Nasdaq is, because there is theconnectivity and things are really fast, that there is no incentive to put ordersin the book. If the market moves, I can go in, zap, in nanoseconds. Theturnaround time in SuperSoes is now a sub second, about 2/10 of a second.What is your incentive to put the order in the book when the people who arepaying attention are 2/10 of a second away from that execution?SCHWARTZ: This conversation about limit orders really pointssomething up. The key to improving market structure is to have anenvironment where people are willing to step forward and prepositionthemselves. As they do so, liquidity is brought out. It is not just a questionof connecting the liquidity pools that are already there. It is a question ofhaving an environment that will allow a liquidity pool to build naturally.Under the ITS trade through rules, a participant is not allowed to trade a stock at aninferior price to the displayed price in a different market.
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SMALL: Absolutely. Look at the fight that has gone on with ECNsand Nasdaq in liquidity rebates. I mean, it is an incredible fight to get thatliquidity in the book.SCHWARTZ: Mark, would you say a word about SuperMontage, andabout how it may or may not help?MADOFF: How does SuperMontage help? SuperMontage makes youfear, ‘Oh, I am going to miss something,’ because of the way the bookprocesses the orders. SuperMontage can bum through multiple levels, and itfreezes people from getting in at the times that hurt investors. In today’sworld, in other words, you can keep pumping in at the next level down. OnSuperMontage, however, you cannot do that. You process what is there, andthen you publish a quote. If you want to be represented at the second levelbut you don’t have an order in, you would miss it. The trade would go rightthrough you.SCHWARTZ: There is another question from the audience. Seth?MERRIN [From the Floor]: I understand a lot of the things that wehave been talking about in terms of aggregating the ECNs up. But, gettingback to something that Andy said earlier, we are still talking about smallexecution sizes. The disconnect that I have always had, that I really do notunderstand, is between a portfolio manager’s desire and his orders, and thetrading desk’s ability to get those orders filled. I understand from a personalperspective that if you go out on a limb doing 750,000 shares while theaverage daily volume is 50,000, you can look stupid. So, how do youreconcile the disconnect between what the portfolio manager really wants todo – whether he wants to buy a million shares or sell a million shares –versus the trader’s personality conflict in actually being there for the game?BROOKS: That is a million dollar question, Seth. I would answer itthis way. Every portfolio manager, just like every trader including