From Traders Magazine, October 1997 issue
When the Pacific Stock Exchange (PCX) received Securities and Exchange Commission approval last month to operate the OptiMark trading system, the pioneer of the new electronic facility, William Lupien, breathed a sigh of relief.
This was one of the many hurdles Lupien had to overcome before his latest brainchild, OptiMark, a black box that executes block orders with unprecedented anonymity, becomes the Instinet of the 21st century. While an Instinet comparison is not entirely fair, it is hard to talk about Lupien’s accomplishments without mentioning the looming presence of Instinet, the trading system he made into a global powerhouse.
In his five years at Instinet, Lupien, a former PCX specialist trader, presided over a 1,100 percent increase in trading volume, enough for Reuters to pay millions of dollars to acquire the system.
Not satisfied, Lupien now wants to upstage Instinet, starting with listed business. He hopes to turn OptiMark, a product of Durango, Colo.-based OptiMark Technologies, into the most important technological innovation to hit Wall Street in a long time. In order to achieve this ambition, he co-developed a patent with Terry Rickard, a Ph.D. in engineering physics and an industry veteran. The patent approval is pending.
“Most recent innovations in the financial markets are technology driven, but they are not changing the process,” Lupien said.
Moreover, Lupien and his crew of tech whizzes are digging in to the batter’s box. At the moment, OptiMark, using a methodology some experts contend is revolutionary, is one of the most hyped and talked about trading systems on Wall Street – though it is still in beta-testing with many bugs to be fixed.
Nevertheless, it remains an elegant and efficient system. “It is a very neat idea, as it is trying to solve a complex algorithm in a very dynamic environment,” said Richard A. Holway, director of trading at Investment Advisors in Minneapolis.
“This is an intriguing product, and it is the first new system which tackles the issues of the new trading environment,” added Michael Murphy, director of trading at Kern Capital Management, New York.
OptiMark is trying to provide an opportunity to investors who want to buy or sell huge positions in certain stocks with complete anonymity and at the best possible price. The trading system’s core, the brain of the machine, tries to optimize the price for a particular equity suitable both to the buyer and the seller, using a mathematical algorithm.
For example, if an institutional money manager wants to sell his stake of a million shares, in say Phillip Morris, he can do so without the risk of other traders finding out about the trade.
If the same trade was to happen on the floor of the New York Stock Exchange, the rest of the crowd could easily participate in the action and drive the price of the share down, before the original seller could get rid of his block at a desirable price.
This phenomenon is known as “market impact,” and market analysts have estimated that the cost of market impact associated with buying and selling significant blocks of stock – as institutional investors do everyday – can run to more than ten times the commission cost.
In other words, since the commission institutions typically pay to buy a share of stock is approximately six cents, the market-impact cost runs to 60 cents per share, or more. Given the level of institutional trading today, the negative effect of market impact on investment returns – affecting all investors small and large – can be measured in billions of dollars per annum for the U.S. markets alone.
Lupien said this is one of the main reasons the markets lack liquidity, adding that liquidity is very necessary if the current levels of volatility are to be tamed. He added that 96 percent of traders want anonymity to execute their trades.
It is no surprise the system has garnered significant support from equity traders who plan to use it. “The innovations will enhance our ability to provide efficient and lower-cost trading,” said Theodore E. James Jr., managing director of capital markets at San Francisco-based Van Kasper & Company. Peter Jenkins, head of trading at New York’s Scudder, Stevens and Clark, agreed, saying OptiMark squarely meets the needs of institutional traders.
Others, like Holway, are slightly more cautious. “In theory, this makes a lot of sense,” he said. “The problem with black boxes is that they are not flexible. A case-in-point is the Arizona Stock Exchange, which raised hopes to a fever pitch, only to stumble later. Where such systems fail is trying to put the theory to practice.”
Added Holway, “There have been a lot of attempts to come-up with the holy grail, and it seems they are getting very close to putting together the algorithm that will mimic an exchange.”
Holway, who is on the advisory committee for OptiMark, thinks it will be some time before the system will make any discernible impact. First, OptiMark has to get the engine working efficiently. And he feels that the company has to address a raft of issues before the system can become the dominant force it is intended to be.
One shortcoming, in Holway’s view, is that a trader has to focus on one stock on one screen, which taps into his already stretched resources, like time. Holway is confident, nonetheless, that Lupien can plug this hole, and thinks that Lupien’s trading experience and willingness to share the development experience with institutions will be very helpful.
There is the question of liquidity, of course, which all but killed earlier attempts to launch other electronic systems. Lupien responds that OptiMark has signed 50 of the top 200 institutions, and very soon will announce new members in the program.
“They need a lot of institutions using this product, and if they can get the top 100 guys using it, then everybody will jump on board,” Murphy said. He thinks while Lupien can easily overcome the technology kinks, his biggest problem will be educating the users, despite the attention he is getting from all parties.
Lupien, however, has a receptive audience in the buy-side trading community. “This is a tool more valuable to the buy-side trader, since it levels the playing field,” Murphy added.
Even so, buy-side traders are not going to use the system at all times. “I am not going to use the system to do all of my business, and I think I would need traditional brokers to do a lot of my trades,” Murphy said.
Nevertheless, he believes there will be some opposition to the system, which challenges some of the conventions in trading. Murphy believes professionals at the hedge funds are going to hate the system. So will the New York Stock Exchange, which wants OptiMark to adhere to the rules that require exchanges to display bid or offer prices better than those prevailing elsewhere.
So far, OptiMark has the backing of some powerful allies, like the PCX and the SEC. Though it is a new trading system, OptiMark will integrate seamlessly within the overall equity-market structure. As a facility of the PCX, OptiMark will be subject to PCX oversight, and will be required to function in compliance with current exchange rules and regulations. The system will also be fully integrated into the National Market System (NMS) through the Intermarket Trading System.
In its Sept. 18 approval order, the SEC found that the PCX application of OptiMark “would further the purposes of Section 11A of the Securities Exchange Act of 1934, and the development of an NMS by promoting economically efficient execution of securities transactions, fair competition among markets, best execution of customer orders and an opportunity for orders to be executed without the participation of a dealer.”
The approval order also noted that “the PCX application provides a new and potentially more efficient way for the SEC to match and execute trading interest. The application appears principally designed to meet the demands of sophisticated portfolio managers, and other market professionals implementing complex trading strategies. These market participants often require instantaneous access to the market, and desire to minimize the market impact of their transactions through the expression of varied trading interests on a confidential basis. At the same, the application is designed to allow retail customers, through member users, to interact with institutional trading interests.”
This approval also helps OptiMark target other markets as well, including Nasdaq, which is “screaming for a system like this,” Murphy said. The company is also planning to bring out a follow-up service, OptiMark System for Options, which will be offered to investors through both the PCX and the Chicago Board Options Exchange.
However, before all this happens, Lupien has to make sure that the system goes through a smooth launch in the first quartet of 1998. No wonder the former IBM-specialist is a tense man, for there are not enough hours in the day. But, as Holway points out – if any body can pull it off, it is Lupien, the innovator.
How New Block Trading System Works
Traders and investors using the OptiMark trading system will be able to electronically submit, in complete secrecy to a central computer facility, their indications of interest to buy or sell securities. In addition, they can program the system with relative ease to express their willingness to trade at a variety of prices and sizes, something which has no real equivalent at the moment.
For example, if an investor wanted to sell 100,000 shares of IBM, he can do so in many ways. He can wait for the computer to come up with a match for his block at his asking price of $100 a share.
Alternatively, he can use the other, more complex route. He can break his 100,000 lot into separate grids. For example, he may indicate that he will sell 75,000 shares for $100 1/8; 50,000 at $100 1/4 or 25,000 at $100 1/2. In addition, he can enter a footnote into the system: any trade can be plus or minus 1/16 a share, if the majority of preset trading requirements are met. OptiMark calls this the investor’s level of satisfaction.
Once brokers have submitted their investment profiles into OptiMark, the system will try to instantaneously match up the buy and sell profiles in a manner that maximizes the mutual satisfaction of both sides of the trade.
The initial brokers users are members or correspondents of the Pacific Stock Exchange, which is the first exchange to make OptiMark available to investors for U.S. listed equities.
One of the main reasons OptiMark promises to become a huge success is the price optimization feature, an aspect many of the existing electronic systems, like Instinet, ITG’s Posit and the Arizona Stock Exchange, lack. At best, they are able to meet about ten percent of the total orders received.
The advantage with OptiMark is that traders do not need any new hardware. Instead, they simply load-up a software program written in Java-programming language, and start trading. The company will provide the software, free of charge.
Investors will be able to send their interest profiles from their desktop computers directly to OptiMark over a variety of information and communication networks, such as the Dow Jones Markets and Bridge Networks.