Defining a block in the 21st century

The industry needs to adjust its perception of what a block is to reflect the current reality, writes Jeffrey O’Connor, senior execution consultant, market insight analyst, US equities at Liquidnet.

Block trading is a long-established and vital function of equity markets. As an industry, we define a “block” as a sizeable trade that will minimise market impact and information leakage by interacting only with selective orders in the marketplace. In practical terms, this means that we generally interact with a small percentage of orders placed in the market, which will vary by stock and market conditions.

The traditional definition of a block has not changed in terms of number of shares since the late 1990s. In fact, we can trace back the origin of this concept to the initial Reg NMS rules about displayed order quantity. Today, most traders and venues use the default static value of either 10,000 shares or 5,000 shares to define a block. But given how much the market has changed since the original definition of a block was coined, is the current definition truly reflective of the current market or with one’s objective in “trading a block”?

A different market

Average trade sizes have decreased and finding true institutional-size liquidity has been challenging in the recent years, resulting in blocks under the traditional definition becoming less frequent. A number of factors have contributed to this evolution, in particular, a significant rise in stock valuations running concurrent with a sharp reduction in stock splits.

The combination of reduced stock splits and growth in market capitalisation has driven the price of individual stocks to many multiples of where they were ten years ago. This is where the dichotomy in our market structure becomes an issue. In the US, investors and portfolio managers think of an investment in terms of its dollar value, whereas the trading community thinks in terms of number of shares. For example, one million dollars’ worth of investments yields a much smaller tradable share count today compared to 10 or so years back.

Redefining blocks

The best approach to finding institutional-size, quality liquidity (blocks) comes down to the percentage of the available liquidity and number of orders one wishes to interact with in the marketplace ‒ in other words, how selective do you want to be in who you interact with and the amount of liquidity you want to be exposed to? 

In addition to using minimum fill sizes to find institutional size liquidity (in defining a block), it has become best practice to weed out ‘smaller’ fills which leak information, either due to pinging efforts or by observation of the tape looking for execution patterns. Although a fixed minimum execution size can achieve this goal, it may also keep us from interacting with meaningful liquidity.

It is therefore important to understand the reasoning behind setting a minimum execution size on an order. Is it to protect the order? Or is it to be selective and only look to interact with institutional-size liquidity? Taking the latter as an example, there are three factors pertinent to consider on an individual stock basis:

  1. The distribution of a stock’s trade size
  2. The frequency of trade sizes per stock
  3. The amount of liquidity across various trade sizes 

In modern markets, block quantity is not a static value. It is a value derived dynamically based on investors’ appetite for finding liquidity and the amount of exposure they want to have in the market. When considering the amount of exposure traders are willing to take, they should consider the balance between the percent of orders you want to interact with versus the quantity/value of liquidity. Moreover, this value is stock specific, calling for a dynamic approach for trading blocks. 

A new definition

The widely held “definition of a block” as a fixed quantity has held sway for many years. Established in 2005, Reg NMS brought high levels of change in a relatively short period of time, with market (and hence liquidity) fragmentation being the most far-reaching impact. This fragmentation, coupled with the surge in stock prices, has resulted in a decrease in average trade size and frequency of large prints in the marketplace.

As it pertains to conditional routing, the utilisation of routing and aggregation by broker/ dealers gained momentum over the last decade. But as it has evolved, going from skepticism to relatively wide-spread acceptance, the minimum fill size setting on routed orders largely remained steady, with most broker/dealers defining a block as 10,000 or 5,000 shares, without due consideration to the specific characteristics of a stock. 

It is with this in mind, and through years of watching traders with minimum fill sizes that often were irrelevant to the characteristics of a stock, that proprietary models became most effective in dealing with modern blocks. This model optimises the minimum fill size to ensure appropriate levels of block-seeking per symbol, while preserving the exclusivity of trading with a select few large orders in a particular stock. 

It seems odd that the evolutionary change in the marketplace has far outpaced what has been a widely used trading tactic to navigate it. The industry needs to adjust its perception of what a block is to reflect the current reality.