Block Trading Boost As Market Correlation Slides

Terry Flanagan

With equities trading volume drying up through the beginning of the year, institutions are turning to block trading as the markets become less correlated.

“We’ve seen an increasing amount of institutions trading blocks,” Tim Mahoney, chief executive of Bids Trading, told Markets Media. “We are not back to having super-size blocks, but people are trading in larger sizes and fundamental investors and traders are able to make fundamental decisions.

“This is opposed to last year, when you saw much more of the markets being driven by macro effects. During the periods of high volatility, institutions were often executing orders with algorithms spread out over longer periods time.”

Bids Trading, which operates an alternative trading system, on average during February traded about 71.3 million shares per day. While that is down about 4% from the same time a year ago, it is performing well compared to the markets as a whole, which are down closer to 10%-15%, according to Mahoney. “Volumes are clearly lower than what participants had expected,” he said. “They were expecting volumes in the seven to eight billion range, and rather we’ve been around six to seven billion.”

Monday, March 12, saw the lowest equities trading volume to date this year, with just 5.2 billion shares traded.

Bids Trading rival Liquidnet has also seen strong performance compared to the market as a whole, with U.S. average daily volume in January up 80% month-over-month, trading 1.2 billion shares. This growth outpaced the volume growth in the overall market which increased 9% from December to January. In EMEA, total principal traded in Liquidnet and average daily principal were both up more than 111% month-over-month. Liquidnet Canada had similar growth as well, up 118% in total volume month-over-month.  Asia-Pacific saw an increase of 9% in total principal traded month-over-month, so not as extreme as the other regions.

While some market participants may lament the depressed volumes, some are seeing it as a return of fundamentals.

“Low volatility creates an investors’ market,” said Mahoney.

In general, if volatility goes down so does high-frequency trading. And a decline in high-frequency trading often leads to an increase in larger block trading. Together with the fact that inflows into equity mutual funds have been on the rise thus far in 2012, and it’s creating a more comfortable environment for traders.

When market volatility is low, assets, particularly single stocks, have lower correlation. This allows portfolio managers to pick stocks based on fundamental factors, rather than macroeconomic factors. During the summer months of 2011, when volatility spiked, all stocks seemingly moved in unison. “[In times of low volatility] you have stocks moving independently of other stocks, which benefits investors,” said Mahoney.

During times of low volatility, when the markets are not highly correlated, a portfolio manager can examine a stock based on its fundamentals, including its financials, its past history and the sector the company operates in. This leaves institutions more confident to buy a block, as there is no fear of that transaction drastically moving the markets.

“That gives you more confidence in being a block trader,” said Mahoney. “If stocks aren’t moving much and there is low volatility, you don’t have to worry about the market moving 200 points after you buy a stock. Lower correlation and lower volatility makes traders more confident in trying to buy or sell large positions quickly, because they can make fundamental decisions.”

During 2011, when there was high correlation and high volatility, it left portfolio managers and block traders in a precarious position. Block trading increases when fundamental managers can confidently pick stocks.

“The market reaction to the European financial crisis is almost entirely event-driven,” Ryan Terpstra, chief executive and founder of financial information company Selerity, told Markets Media. “Traders and investors are watching critical political and economic events, including central bank debt auction results and key legislative bills being passed by Greece and [other] European Union countries, in order to better manage risk, but also to generate sources of alpha.”

Bids Trading is a dark pool operator owned by a consortium of financial institutions, including Bank of America Merrill Lynch, Barclays, Citi, Credit Suisse Group, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Knight Capital Group, Morgan Stanley, NYSE Euronext and UBS. A block trade is usually an order to buy or sell 10,000 shares or more.

Market volatility was high for much of 2011, as the Chicago Board Options Exchange Volatility Index indicated. Two and three percent intraday swings became the norm. The surges came in the wake of a slew of macroeconomic events, including the European debt crisis and the U.S. debt downgrade. The VIX reached a high of 48 on August 8, 2011, as the markets reacted to the lengthy U.S. debt ceiling negotiations and the Standard & Poor’s downgrade of U.S. debt. Since late 2011, however, volatility has settled down and has remained in the high-teens and low-twenties. As of mid-day March 14, the VIX was trading at about 15.

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