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Wall Street After Equities
The Big Board's New Rival
Dan Kruger, 08.21.03, 12:00 PM ET

NEW YORK - Institutional traders looking for ways to reduce market volatility are increasingly turning to a two-year-old upstart alternate trading system called Liquidnet.

It's no imminent threat to the New York Stock Exchange and the Nasdaq National Market, however. Liquidnet averages a mere 12 million shares traded a day, while the Big Board routinely has 1 billion-share days. But Liquidnet's small measure of success should not be ignored. The system is "starting to gain critical mass," says Andrew Brooks, head equity trader at T. Rowe Price.

New York-based Liquidnet was originally designed to be home to trades for hard-to-trade small- and mid-cap stocks. Trades are made anonymously between buyer and seller (each party is alerted to the other's presence through Liquidnet's software).

Theoretically it makes most sense for traders to use Liquidnet for companies such as Wilmington Trust (nyse: WL - news - people ), Matthews International (nasdaq: MATW - news - people ) and Lindsay Manufacturing (nyse: LNN - news - people ), which are not awash in volume; yet the heaviest traffic on the system is often in stocks such as General Electric (nyse: GE - news - people ) and Boeing (nyse: BA - news - people ).

Trades are negotiated between the two parties, often using the midpoint of the bid-ask spread as the start point. A similar system by New York-based Harborside employs a trading desk to conduct negotiations, keeping the buyer and seller unaware of whom they're trading with.

For an industry rife with chatter and rumor, such cloak-and-dagger secrecy can help mitigate volatility. How? By keeping trades off the exchange floor, traders minimize the potential impact for, say, a big sell order on a small-cap stock to sink shares in the open market. Conversely, a big buy order on Liquidnet can keep you from turning a value stock into a growth stock through your order alone.

Liquidnet has 196 institutions signed onto its system. Together those firms have $5.7 trillion of assets under management. It takes 65% of its volume from the Big Board, 34% from Nasdaq and the rest from the American Stock Exchange. Harborside doesn't reveal details about its own volume, citing the need to protect the anonymity of its clients.

While some speculate that Harborside's lack of data is a way to mask small trading volumes, the concern traders have about how information on their orders will be used is plenty real. Traders hate it when a small buy order comes in just a penny better than their much bigger buy order. The smaller buyer is often able to sell those shares to the trader with the bigger order at an inflated price after driving up the market--a practice known as "penny jumping."

Penny jumping got its start in 2001 when the NYSE and then Nasdaq moved to trading in increments of pennies from sixteenths of a dollar. Traders trace many ills afflicting their profession to that switch. T. Rowe's Brooks includes intraday volatility in that list. "Do the fundamentals of General Electric dictate a 2% price difference intraday?" he asks. Reacting to that "general frustration" he's doing more trades in big stocks on Liquidnet.

Robert McSweeney, the NYSE's senior vice president of competitive positions, says the numbers suggest Liquidnet and Harborside haven't made deep inroads. During the trading day the Big Board captures more than 80% of the block-sized (10,000 shares and up) trades of listed stocks. "People are voting with their dollars," he says.

At the same time, the stock exchange will continue adding innovations that work well with its auction model. Its new LiquidityQuote program, available for the 28 NYSE stocks included in the Dow Jones industrial average, lists the aggregate volume available outside the best bid or offer.

By the end of the year the NYSE aims to expand the program to those stocks on the S&P 100 that it lists.

http://www.forbes.com/2003/08/21/cz_dk_0821liquid.html