Part III – Liquidity Provider Block Trades
By J. Kolman Estreicher, Wolverine Execution Services (WEX)
Intended for Institutional Investors.
Last month, we highlighted a few ETF trading misconceptions originating from and perpetuated by the electronic marketplace, notably those related to screen liquidity and average daily volume (ADV). Many investors looking to accumulate a large ETF position, or to unwind a large ETF position via the screens, will likely ponder the following question, “How am I supposed to get in/get out of this thing?” Welcome to the block marketplace.
Have you ever looked at the tape and seen a 100-lot print followed by a print for several hundred thousand shares just a penny or two worse than the previous price received and wondered how that could happen? This is the block marketplace at work. What’s interesting is that with all of the modern day advances in trading technology to reduce latency and maximize information efficiency, the block marketplace is predominantly a voice market. While this may seem counterintuitive, the block market will probably not evolve to an electronic model for many reasons that can be traced back to the Flash Crash on May 6th, 2010. Quite simply, there’s far too much risk.
The block market is really comprised of two types of execution venues, liquidity providers (LPs) and agency services. This month we’re going to take a closer look at the different types of LP market participants and how they provide liquidity. There are five types of LPs: high frequency traders, buy-side investors, relative value traders, NAV traders, and market markers. However, for purposes of block trading, high frequency traders and buy-side investors are not relevant. High frequency traders rarely, if ever, provide off-screen liquidity, and they typically trade in tiny increments while posting very tight markets. Buy-side investors are irrelevant because they are an unpredictable and unreliable source of liquidity due to strategy, policy or operational constraints, to name a few. Furthermore, they are not required by any of the exchanges or regulatory bodies to provide liquidity to anyone.
Relative value traders, NAV traders and market makers are the most active LPs in the block marketplace, and their approach to trading varies. Relative value traders use pairs trading techniques or other risk arbitrage strategies to derive prices from correlated securities. Simply put, the relative value trader will evaluate the relationships between ETF A and ETF B, futures, swaps or other asset classes to determine how to price securities.
NAV traders make their markets based upon where the underlying components price up to the net asset value (NAV), and they represent the true block liquidity in the marketplace. The price valuation capabilities of a NAV trader are what prevent prolonged pricing dislocations in an ETF. For example, if an ETF is trading at a discount to its underlying components, the NAV trader will buy the ETF and short the components. Conversely, if the ETF is trading at a premium to its components, the NAV trader will short the ETF and buy its components.
Market makers can use the same techniques of a relative value trader and NAV trader to make a market on the ETF and/or the underlying components. Market makers are obligated to display two-sided quotes and they have both liquidity and quote duration requirements. Market makers typically strive to be position neutral, or “flat”, at the end of the trading day and therefore they will skew their markets to adjust their book. For example, if a market maker is long a position, they will naturally be more “offered” to sell. If they are short a position, they will be more “bid” to buy.
Recognizing that this seesaw-like continuum exists between the bid and offer will help many firms understand why a liquidity provider will rarely, if ever, be both the best bid and the best offer on the same security at the same time in the block marketplace. Since there are several different types of LPs with multiple trading styles, the questions you probably have are twofold: (1) when do you use a specific type of liquidity provider, and (2) how do you know that your decision will produce the best result for your block execution?
Next month we’ll examine how our last execution venue, the Agency Service, uses their relationships to work within this bid/offer continuum, which ultimately governs their approach to sourcing liquidity.
Headquartered in Chicago, WEX specializes in value-added execution, enabling institutional clients to trade equities, options, futures, and ETFs through our proprietary electronic trading platform (WTP), algorithms, floor access, and agency brokerage desk.
This is intended for informational and discussion purposes only and does not create any legally binding obligations on the part of Wolverine Execution Services, LLC and/or its affiliates. Without limitation, this document does not constitute an offer, an invitation to offer or a recommendation to enter into any transaction or investment advice of any kind. For general information regarding the nature and risks of investing please go to www.tradewex.com.