everybody in this room, regardless of what they do, wants to win everysingle time that he or she comes up to the plate. These guys and gals expectus to properly analyze supply and demand and to stretch it a little bit. Yes,they have made the decision to buy shares, but, gee, if there were sellersshouldn’t you have known that? And if it is going lower, shouldn’t we begetting a better price? Why did you buy it at all? Because you told me to(laughter)! But I expected you also to know that there were sellers out there.Our value added as traders is on the margin. For a trader today to stayemployed, it is critically important for him to appreciate where his valueadded is coming from, and to not be an obstructionist. If the portfoliomanager wants to sell it, it is generally not the trader’s imperative tocontradict him.KILLEEN: There is also a level of trust there. You do not get a blankcheck from a portfolio manager with an order. If he gives you an order, he is
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expecting you to work it diligently. It is part of our job and we do not like tolose. We fight for our clients and try to get the best price (if there is a bestprice). There is a lot of second-guessing, and some portfolio managers arehands on. They call every hour and want to know. Hey, I saw something goby. Was that me? Why? Why not?SCHWARTZ: What is your perspective George?SOFIANOS: Andy and Chris’ points both also apply to the sell-sidetraders. What is extremely important is the communication between theportfolio manager, the sell-side trader, and the buy-side trader. There mustbe a good understanding of what the buy-side wants. There is a desire to actin the context of those instructions. One of the greatest lessons I learnedwhen I moved from the New York Stock Exchange to Goldman, was howimportant the relationships are between the buy-side and the sell-side. I amthinking of the personal relationships, where they can talk and exchangeideas and provide information and context for each execution.SMALL: I have another observation. Looking forward, we have gotinvestment returns in the neighborhood of – Buffet expects 6 ½ % for thenext five or six years. If so, trading is going to be a very critical part of theinvestment process. What Andy said about the buy-side trader’s value addedbeing on the margin is correct. But the margin can be critically important.If he can add 40, 50, or 60 basis points, that is the difference between a topdecile manager and a third or fourth decile manager. You are right, Seth. Ifliquidity is there, why not just grab it? But (and this is Andy’s point), if youcan buy part of it and then buy the rest smarter, you can really drive theperformance of your organization.RICHARD REPETTO45 [From the Floor]: Two questions. First, thereare right now front-end aggregators in the Nasdaq market. I would like tohear your opinions about them, specifically the market makers. Second, wetalked about limit orders. That is maybe the first phase in driving changes tomarket structure. My second question is for Bruce. There is an incentivewith SuperMontage to add liquidity, you know, the dime per hundredrebates. Do you think that that will incent liquidity? You also get an ECN(say Island), that will pay people a penny more. Do you think you can get tothe point where you can really incent material liquidity on the book?TURNER: That is an interesting story. First, a quick history on theliquidity rebates. Nasdaq pays 10 cents per hundred, and they charge 20cents per hundred, so we call it one mil two mils. I think the Instinet ratio is2-3. What has happened is, everyone figures that they can survive with the45
Richard Repetto is currently Associate Director at Sandler O’Neill & Partners, LP. At thetime of the conference, he was a Managing Director at Putnam Lovell.
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one mil net to them. What they are saying is, ok, I will pay 2 and charge 3.Now there is an ECN out there giving 5 and charging 7. That’s a two milsspread. At some point this will end if traders and subscribers stop paying theaccess fee of 7. At some point, the ECN will stop rebating the 5 whensubscribers stop paying the 7 mils when they get executed against. Youcan’t pay 5 if you are not getting 7. But the liquidity rebate has beeneffective.46Look at the statistics behind LightSpeed. They have garnered a lot offlow from the day trading community because of their liquidity rebate. Yes,it is effective. The real issue, though, is the following. You mentioned theaggregators – you have got Lava Trading and you have got a lot of otheraggregators out there. They are aggregating what people are willing to putin. All of us on the sell-side have these order books. We only put the top ofthe file in there. There is a lot of liquidity out there that is not in anything.The trick is to find an incentive mechanism to get those orders into them. Soyou have got Lava Trading. But if you miss it with Lava, you can still be atthe next level. You can still get it in there. SuperMontage has got that extrakick. If you are not in there and the market burns through a couple of levels,you will miss the execution. It may be a slight distinction, but I think that itis an important one.REPETTO [From the Floor]: Bruce answered most of my question.One additional piece is that the aggregators are only as good as the firms anddesks that are willing to provide the information to them. That iscomplicated and changing. Also, a number of the aggregators will not talkto one another. You have individuals that are trading within one system and,for a host of reasons, that system will not talk to another. That becomes aproblem. It is complicated because you could have an individual who hasopted to put an order into ECN A, but ECN A does not want to talk to ECNB, and the only way that those orders will ever interact with one another –certainly on the listed side – is if somebody does an arbitrage between thetwo systems.46
As of mid-2003, the liquidity rebates and access fees discussed by Turner were a subject ofmajor debate in the trading industry. These rebates and fees are part of the pricing modelused by ECNs and SuperMontage in the U.S. Liquidity rebates are paid to a trading firmeach time it submits a standing order – a limit order or quote – that is executed. However,if the firm, seeing a posted bid or offer in an ECN responds by lifting or hitting that restingorder, it is charged an access fee. The most common charge is referred to as ‘3-2’,meaning 30 cents is charged for taking liquidity while 20 cents is paid for providingliquidity. Market makers have been lobbying against the access fees, on the grounds thatthey are inequitable. Market makers are not permitted to charge access fees. Access feesraise another issue. Best execution obligations can force a market maker to use an ECNoffering the best price even though the market maker may incur an access fee. This is amotivation for market maker ECN subscribers not to pay access fees.
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SOFIANOS: There are some concerns about aggregators. They do agreat job for relatively small orders. For an active Nasdaq stock, forexample, the displayed inside quote is, perhaps, 100 shares or 200 shares.You can aggregate it all over the place, and the aggregate will still berelatively small. Should the electronic aggregators start walking up the limitorder books? The problem is, when you are walking up the books, youignore the non-displayed liquidity in the market, and the aggregators are notdoing a good job with liquidity that is not displayed.SCHWARTZ: That is Bruce’s point.SOFIANOS: So, there is this tight limit, up to which you can use theseaggregators. Actually, it is tight because, for an active stock, to aggregatethe inside quote, you do not get very much liquidity. There simply is solittle on the inside quote. However, any attempt to go beyond the insidequote with an electronic mechanism causes you to miss all of the nondisplayed liquidity. That is where a traditional broker dealer’s value-addedcomes in.SCHWARTZ: Yes, the non-displayed liquidity is a very interestingcomponent of market quality. And it is very much a function of the systemsthat we have.WAGNER [From the Floor]: I want to expand a bit on what Seth wassaying. You have to go back to the portfolio manager. When you aretalking about market structure, what you are trying to equate is the desire tobuy with the desire to sell. The only thing that you have to do that with isprice. Price has to move to a point where you equate the number of shares tobe bought with the number of shares to be sold.SCHWARTZ: Yes, but Wayne, you still have to get people to take theorders out of their pockets so that...WAGNER [From the Floor]: They may not be in their pockets. Theymay not want to trade until they see the action that is going on in the stock.SCHWARTZ: Sure. But that is the non-displayed liquidity.WAGNER [From the Floor]: It is more than non-displayed – it is nondisplayable. If you were, say, a hedge fund looking to ride in on some actionthat is going on in the market at the time, the market action itself is themotivating factor that brings liquidity to the other side.BROOKS: That gets back to trusting the price, to trusting the pricingmechanism, to trusting that the prospective price is going to be somethingthat you are going to be comfortable with. And as to a point that the fellowsdown the line here have made, if we can incent people and reward them fordisplaying orders and for aggregating those orders on a book or on a facilitythat is accessible, then, just maybe, what moves the price is actuallysomething legitimate.
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One of the reasons why you can feel stupid is that, after the 750,000share print is done, a 3,000-share print moves the stock 25 cents. If it took75,000 shares to move that price because there were all of these displayedorders at different levels that you have to get through, I would not feel sobad. I would probably be more inclined to put some orders on the bookmyself. It is when price moves, for no reason, for nothing that makes sense.When simply, because somebody can do it and profit from it, that pricemoves – that is what causes a lot of us to hesitate to display.TIEFENBRUN [From the Floor]: The fragmentation issue amongECNs that we talk about today is a red herring. To the best of myknowledge, all of the ECNs are very tightly connected. I do not know of anyexamples where one ECN will not talk to another when it comes to fillingorders. The fragmentation problem, which SuperMontage addresses in part,is that the broker dealers are maintaining order books that they are notpublicly disclosing, that they are not providing access to, and that they arenot providing visibility to – to anybody.The ECNs are the good guys here. They publish their entire book, andthere are many aggregators. All of the ECNs offer the market smart routingand aggregated views, etc. The problem lies with the traditional brokerdealer who has an order book that is not yet published.VIKTORIA DALKO47 [From the Floor]: I have two questions. First,according to your experience, what is the minimum sized order that willhave a meaningful price impact? We saw statistics of 30 basis points and soon, but do you have a minimum order size that will cause this kind of a pricemovement?Second, regarding the market makers, do you find that they can affect theprice, or are they completely neutral in the process?TURNER: Andy, do you want to answer the second one (laughter)?BROOKS: No, Bruce. I am going to let you handle that one(laughter)?TURNER: Taking the second first, market makers, of course, caninfluence the price. Price responds to what is out there. A lack of depth inthe book enables people to move prices more than they think should happenin our markets. We need to get more orders in there. More orders wouldcontrol that movement of, in Andy’s scenario, down 25 cents on 3000shares.As for the first question, I do not think that there is any minimum sizethat can move a market. There are too many variables involved. Scenarios
47
Viktoria Dalko is President of the RICE Institute.
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could be created where minimal size could move stocks dramatic percentageamounts, and vice versa.PAUL DAVIS48 [From the Floor]: I have an observation. I like thedistinction between displayed liquidity and un-disclosed liquidity. Myintuition is that the combination of SuperMontage and Liquidity Tracker willbe dynamite. You can distinguish between the displayed liquidity onSuperMontage and the un-displayed liquidity that you can get to withLiquidity Tracker. I am very excited about this combination. I am anxiousto see it in play.SCHWARTZ: Thank you.Time is moving. I would next like to get a closing comment from eachof the panelists. Let me give you a little platform to start with. We have hadsome sizable market structure changes of late. The order handling rules, forinstance. Then there has been decimalization and all sorts of technologychange. What overall impact has all of this had? Could each of you give usa bottom line on your view of market quality today? Has it improved, or hasit deteriorated? Bruce, how about you leading off?TURNER: I am not sure I can do this in two minutes. We have seen aconfluence of events. Best execution is key, and the SEC’s 11Ac1-5 and 6 ison everyone’s mind right now. You have decimals and order handling rules,and you can combine all of that with what has been a pretty lousy tape. Atthe end of the day, we must create a better marketplace by incenting moreorders in the book. We gave a lot of emphasis to that on this panel.It can be done. I feel strongly about it. I am hard pressed to say if thingsare better in aggregate. With decimals, retail investors have been richlyrewarded. Their execution costs are down. However, the last studies that Ihave seen say that, for the institutional community, the verdict is still out. Isit better for some? Yes. But is it better for all? I do not know.The limit order handling rules definitely benefited the market. There isno question about it. The continuance of that is SuperMontage. The abilityof people to put more orders in the book will make things better foreverybody.SOFIANOS: When looking at market quality and where we are now,given all these market structure changes, I like to distinguish between small,easy orders and large, difficult orders. For the easy orders, the answer isstraightforward. We have a very competitive market, lots of alternatives,and lots of publicly available data. The SEC’s 11Ac-5 data, if usedcorrectly, can help us make informed decisions. We have competitivepressure on explicit fees, competitive pressure on spreads, and trading costs48
Paul Davis is Senior Managing Director at TIAA-CREF Investment Management LLC.
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are much lower than they used to be. They can’t get much lower on thesmall, easy orders. We are pretty much there. On the smaller end of themarket, fragmentation also does not worry me because we have all thosesmart routers and electronic ways of accessing liquidity.The difficult orders are where we still face challenges. It is still amixed bag. Fragmentation makes it more difficult to aggregate liquidity.More fundamentally, as I have alluded to earlier, most of the liquidityremains non-displayed. I personally believe that most of the liquidity willalways remain not displayed on the buy-side. The challenge, of course, is totap this non-displayed liquidity. Another problem for the large orders is thatthere is little publicly available information out there to make informedchoices on where to route your orders. Perhaps little that can be done aboutthis.I looked at the Goldman Sachs data. We found that the switch topennies reduced trading costs across all size segments, including the largeinstitutional size orders. But remember, this is from the sell-side. I also hearfrom the sell-side that they are finding it much more difficult to execute nowbecause there is much less displayed liquidity. However, from our point ofview, trading costs have gone down. Even after I back out the explicitcommissions that Goldman has been charging on Nasdaq trades sinceJanuarytrading costs are lower now, across almost all size segments,than they were before pennies.SMALL: The quality of the markets has deteriorated, but for goodreason. We are in a transition period. We are absorbing the changes. Thefuture is very, very bright for the markets to come out of this in a morecentralized, aggregated fashion. In the future, the markets will be muchmore efficient. But we are feeling the pain now.The pain is in conjunction with the bear market that we are experiencingat the same time. The bear market has put added pressure on everyone.Nevertheless, as tough as it is to execute size, ultimately we will be OK.The SEC is going to do the right thing by letting the markets decide howthey will develop. I am as encouraged as I have been in the last few yearsabout being able to get the job done.MADOFF: I do not mean to contradict your opening statement, Bob,but I think the quality of our markets has never been better. We have seenan increased number of players. We can see some of the competitive spirithere in this room, between myself, the exchanges, the ECNs, and the ATSs.That is a tremendous positive. Execution costs have gone downdramatically. ECN fees have gone down dramatically. We are getting fasterexecutions. Each year, average execution speed goes down. The effectivespreads in stocks are constantly declining. Combining the 11Ac1-5 data
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with better evaluative tools will enable everybody out there, who is willingto put in the time, to get a better idea of what is going on.We need to embrace the spirit of competition. Let the ECNs, the ATSs,the regionals, the exchanges, and the market makers all compete with oneanother. Lets level the playing field as best we can through competition,through linking everybody together. Lets allow that competition to takeplace. I think we will see better and better executions over time.KILLEEN: I am an optimist and I agree with Mark. We are headed inthe right direction. We have also touched on the point that, in the currentbear market environment, trading costs are very important. We are trying tosave some money and improve performance in any way we can, especiallyfrom the trading desk standpoint.The order handling rules have basically helped the market by givingthe buy-side a little more control over our orders. Some fancy software hascome about through competition that has allowed us to work our orders moreintelligently. Even though the orders are somewhat piecemealed, we nowhave more hands on, which helps price discovery.The New York Stock Exchange has a ways to go. The NYSE has startedthis Open Book, which can be helpful with some stocks that do not tradewell. At least the NYSE is coming to the table bringing something, insteadof just relaying on an agent or trying to find something short of capital tomake something happen.We are not there yet. I do not know if we will ever be there. On thebuy-side, we always say we want the perfect market. We always wanteveryone to open up. But then, if we could see down the road, I think wewould back off. We are headed in the right direction, and competition is theway to go.BROOKS: I guess the quality of the market is better. I also think thatwe could do a lot better. We must continue to find ways to incent andreward people to display and to be willing to trade. This market has gonethrough a lot of change in the past few years. We ought to move moreslowly now, because we need to digest some of the changes. Innovationcomes at a cost. Innovation has been terrific. The competition that hasresulted from the innovation has been terrific.But we do havefragmentation, and all of the issues that come from it. We have got to find away to require some level playing fields. I am not sure that all of the fieldsare level right now. There are way too many sharp shooters out there takingadvantage of order flow, causing volatility and, in general, doing things thatare not as legitimate as investing ought to be. I realize that this is a verysubjective statement.
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We must continue to analyze the relationship between the quality ofmarkets and intra-day volatility. The volatility that we have has, somehow,to be legitimized.SCHWARTZ: I thank the panel for a very interesting discussion. And Ithank the audience for interacting with them.
CHAPTER 4: VIEW FROM AN ECN
Joel Steinmetz49
An old couple is having trouble remembering things, so they visit adoctor. The doctor tells them, ‘It is really nothing, everything is OK, butmaybe you ought to write things down so you will be sure to rememberthem.’ The couple goes home. Sitting later in their den watching TV, thewife gets up to go to the kitchen. She says to her husband, ‘Can I get youanything?’ He says, ‘I’d like some ice cream with whipped cream on top.’She says, ‘No problem,’ He says, ‘Let’s try what the doctor suggested andwrite it down.’ She says, ‘No, no. Ice cream and whipped cream. I got it.Don’t worry about it.’ She gets closer to the doorway. He says, ‘You knowwhat? I would like some ice cream with whipped cream and hot fudge, but Ithink you ought to write it down like the doctor said.’ She says, ‘Don’tworry about it. Ice cream, whipped cream and hot fudge, a classic. I got it,don’t worry.’ She goes into the kitchen and comes out a few minutes laterwith a toasted English muffin. He says, ‘A toasted English muffin? What?We ran out of bagels?’ (laughter).I’ll come back to that joke later. But let me start by saying that the mediaand industry usually describe Instinet as an electronic communicationsnetwork. We typically describe ourselves as a global electronic agencybroker. The word ‘electronic’ is dominant in both descriptions. We believein electronic solutions. But, interestingly, the electronic solutions providerssuch as ECNs, ATSs, liquidity consolidators and smart order routers, havetaken their eye off the ball. The last great era of growth for the electronicsolutions providers was in the mid- to late 90’s. It was five to seven yearsago when you had the explosion of all these types of players. During thattime, there were problems in the market that we were trying to solve. What49
At the time of the conference, Mr. Steinmetz was Senior Vice President for Equities,Instinet Corporation.
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was needed was an aggregation of information, a consolidation of all theinformation that was in the marketplace. The innovators came up withconsolidated order books. Smart order routing came out of that. New wayswere developed to manage your lists more easily in an environment whereexecution was fragmented.The electronic solutions providers as a group stepped in and did the job.They came up with ways to access multiple pools of liquidity at once. Theycame up with smart order routers, with intelligent algorithms to figure outwhere the best place to trade was. Consolidated order books were developedthat gave you great information.All of these things were good for the marketplace. They provided value.If you were either a retail customer or an institutional investor, you now hadsomething a little better in the marketplace. You could get liquidity better,you could get information better. You could use some intelligent orderrouting to get to the best place to trade. These were important improvementsin the market.The discussion on the previous panel was a microcosm of the issue. Iwill cover some of the same topics as the last panel but from a differentangle. If you noticed, the previous panel started off with the buy-sidedominating the conversation. The reason was that we were talking abouttrading large orders. Doing things that would provide value to investors. Aswe went on, we took our eye off the ball. We forgot, like the joke about theold couple, that we wanted the ice cream. We started talking about thingslike getting to the inside quote, narrowing spreads, and SuperMontage. Andthen finally we came back to the issue: what to do about the large orders?What has basically happened is that all of the electronic solutionsproviders came up with these things in the mid to late 90’s. Those solutionseither created other problems, or there were so many things that had to besolved at that point that the new electronic solutions could not fill the gap.So we came up with ways to reduce fragmentation, and to consolidateinformation, and to route our orders intelligently. We started coming upwith things like reserve quantity, discretionary pricing, and sophisticatedalgorithms. We started branching out into other things. Whether due tomarket conditions, or perhaps just pressure from competition, brokeragecommissions started getting driven down lower and lower. Innovations andmore efficient processes resulted in cost savings. We were looking to solvecost issues, instead of providing value. We were playing the game ofsolving the cost, of getting faster and cheaper, cheaper and faster.But we forgot about providing value. We have to refocus. I will giveyou an example. It is an Instinet example. Around the mid 90’s, we hadsomething that we called an order management system. At that time, ourorder management system focused on the ability to trade lists or baskets of
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stock. We went out to the brokerage community in the mid-90’s to offerthat. Since it was focused on lists and baskets, the natural place for us to putit was at program desks, index arbitrage desks, and the small but growingmodel-driven trading shops. We presented this tool to that group ofcustomers. At the time, there was hardly any list or basket trading in overthe-counter securities. There was just no way to do it. The over-the-counterstructure at the time was such that, if you wanted to trade a basket, eitheryou went to one market maker with the entire basket, or you didn’t trade it.Unless someone wanted to give their entire basket to one particular player(which was the norm when people are bidding for them), they really had noway to trade a list of over-the-counter stocks.We brought in a system that allowed you to manage your orders and totrade those stocks efficiently in multiple liquidity pools whether it was ours,NASDAQ’s or other pools of liquidity. Our system did not just divide upthe same piece of the pie. It didn’t make us go after liquidity that alreadyexisted in the market. Our system created a whole new way of trading for agroup of customers. They were able to put money in the market in adifferent way than they had ever done before. Once you do that, you are notgoing after the same piece of the pie. Rather, you are making a larger pie.In the beginning, we had a disproportionate percentage of that largerpiece of the pie. Once it got out there, it grew to be something that peopleexpected. Then competition started coming in, and people started playing,and then we had a bigger pie for everyone to divide. By focusing onproviding value, we enabled people to use their money in different ways, toprovide extra liquidity to the market so that all market participants couldbenefit.Currently, the main focus is on ‘how can I get to the 200 shares that areoffered quicker and cheaper?’ It is the same 200 shares that are out there. Itdoesn’t really provide me with what I need, but I have to know how I getthere quicker and cheaper. I do not mean to trivialize the importance of that,and we are going after that as well. Enabling people to get to the currentmarket faster and cheaper is definitely a need, it is a value that can beprovided.But we have lost what we have to do to provide value to get to the nextlevel of the market. As was stated before, we must provide something thatwill get those limit orders out in the marketplace. The people who use limitorders must feel comfortable with the way these orders are handled in themarketplace. An investor should be able to put out a large order and feelcomfortable that it will get traded.My view differs somewhat from the previous panel. I am not sure thatthe best way to solve our problems is through market structure or marketquality issues. The best way might be for players who innovate to come up
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with the solutions. It is players like the electronic solutions providers who inthe past have generated much of the innovation. These players must refocustheir energies and look at delivering value, rather than concentratingmyopically on cost or current market conditions. They must go tounderlying needs and provide value so that, overall, the market will grow.Here are some possible solutions. Right now, everyone is talking abouthow important it is to get all the market data in one place. It is important.But, take a look at NASDAQ’s model. Anywhere from 30% to 50% ofNASDAQ trades happen on ECNs. The majority of that kind of order flowis not in the public display. According to some studies, that order flowaccounts for over 70% of the volume handled by ECNs. It is what is calledundisclosed orders. SuperSOES also came up with a reserve feature, andSuperMontage has a reserve feature as well. When you think about it, thevast majority of the data that you need to make your trading decisions is notavailable to be viewed.There must be some other way to come up with the data people need tomake efficient trading decisions. Maybe it is data, maybe it is trends, maybeit is some way of understanding what happens in the first half-hour oftrading. We talked about the first half-hour of trading this morning. Is itthat people are putting their orders in there? Is it because people are puttingin at one price and are actually willing to trade at another price? Is itbecause we saw 10,000 shares when actually there were 10,000,000 sharesavailable?Much information and data can be aggregated and delivered in a verygeneric form to the marketplace. That creates value. Based on ourconversations with buy-side customers, I know that would be something thebuy-side customers could use. That kind of information, and those kind ofelectronic solutions, are the things that we need to focus on to provide value.A second example is one we have spoken about today. It is the big topiclately. It is trading in size. On the NYSE, consistently over the last fewyears, about 50% of all shares are traded in blocks. On NASDAQ, blocktrading had accounted for about a third of all trading, and now it is at about aquarter of all volume. So the decline is not just because of the bear marketconditions. It is down as a proportion of all market trading activity.Regardless, there are a huge number of shares that are traded as blocks. Yetno one feels comfortable actually trading blocks in the traditional way. Thatdoes not mean that there is no need for the traditional way as well, as statedearlier. There definitely, at times, is a need for intermediaries. But theremust be a better way to get to the other side, which is the goal of the buyside.What is the underlying need? I am not sure that the underlying need isnecessarily to get to the other side and knock off 500,000 shares all at once.
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Of course, if you could get 500,000 shares in the same amount of time that itwould take you to call up your broker, and have him match up the 500,000shares, and have the impact on the market be even less, everyone would bepleased. The underlying need is not necessarily to trade a block as a singlelarge trade, which would be nice, but rather to trade a large block effectively,even if it is done in smaller pieces.A refocusing of the electronic solutions providers on these kinds of issueswill provide value to the ultimate investor. The investor could be the retailinvestor. But generally the bulk of the market is represented by retailinvestors going into the institutional community, whether that’s throughpension funds or mutual funds and other institutional investors. For the sakeof the retail