Block Trade Routing
By Sanjay Awasthi, Director, Central Dealing Desk, Eastspring Investments
Different levels of stock liquidity determine whether the best way to transact a block trade is through an algorithm or by human intermediation.
The benefit of transacting in blocks and importance of such trades in achieving optimal price execution is broadly accepted by institutional investors. However, it is necessary to penetrate the surface and explore the intricacies of block trades. The respective roles of technology and human expertise in various situations need scrutiny in order to fully understand how to transact such blocks effectively.
Block transactions can be examined from a perspective that distinguishes between different levels of scale and liquidity, with particular relevance in emerging markets. At the outset, it may be appropriate to distinguish between these two distinct categories of tradeable securities, that is, stocks that are widely held by institutional investors and those that are narrowly held by institutional investors.
Widely-held stocks are generally actively traded. They comprise large- to mid-cap names and often form the core holdings of a diversified portfolio.
The narrowly held category tend to be illiquid and comprise small- to mid- cap and are typically the alpha picks of country (both domestic and foreign) funds and some regional funds. They are usually the main wealth creators and many grow to become large caps and dominant weightings in benchmark indices.
The size of a portfolio is another categorisation that is pertinent when considering how to treat blocks.
The individual order amount of a large fund, typically a global or a regional fund could be the equivalent of multiple days of the average daily trading volume (ADTV) of an active, widely-held stock. Often, it might make up a significant portion of the available free-float available in the market or even the total tradeable equity of a particular company.
Degrees of liquidity
Therefore, access to liquidity will determine whether an order can be filled, and the nature of it will ascertain how best this can be achieved. In practice, a trader needs to differentiate between liquidity that is either undiscovered or non-existent which could be in either widely held stocks or in narrowly held stocks. Assessing the nature of the liquidity available for a stock at a particular time guides the trader in the attempt to complete an order.
Undiscovered liquidity is available in the system as either an order on another dealer’s pad or expressed as an interest to trade by a market participant. These types of order can be matched and transacted as a block trade: some are more suitable for automation, others require the human touch.
Technology-driven block crossing networks such a Liquidnet, POSIT Marketplace and other “indication of interest” (IOI) platforms provide extremely efficient ways for dealers to access available liquidity.
However, human intermediation is also essential to convert an “interest to trade” to the completion of the transaction. The buy-side still requires a network of trusted market relationships established and coordinated by skilled sales traders who can search for a matching interest to trade and close really large blocks.
Buy-side traders need to trust sell-side traders to ensure that information leakage is minimised and that their market isn’t spoiled. The sell-side trader should have critical mass, with access to a wide variety of counterparties, as well as discretion.
Testing the waters can be counter-productive if it disturbs the stock price. Timing can be important and that is where the expertise of a trader is most evident.
Non-existent liquidity is a salient feature of narrowly-held stocks and of orders by large funds whose size is much more than the ADTV of a stock and a significant proportion of its free-float or total number of shares.
Completing these types of trades is tough, and in practice, they could be characterised as quasi investment banking mandates. Again, human networks, professional skills and personal sensitivity are essential ingredients for achieving a successful transaction.
For narrowly-held stocks, there is an additional complication. Many leading brokers do not regularly cover them, so often buy-side firms are forced to approach brokers beyond their usual list to source such liquidity.
Success in such transactions is highly dependent on market relationships and demonstrates the true value of a buy-side dealing desk.
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