Buyers Meet Sellers Online With Computerized Crossing

Like mini skirts and paisley prints, the fourth market is back in fashion.

As soon as it receives SEC approval, Jefferies & Co. is expected to introduce a computerized service for matching buy and sell orders known as the Portfolio System for Institutional Trading, or POSIT.

Based in Los Angeles, Jefferies is the dominant player in the third market where exchange-listed stocks are traded by telephone over the counter. The securities firm developed POSIT jointly with Barra, a Berkeley, CA financial consulting firm.

POSIT will compete with Crossing Network, which was launched by Instinet Corp. late last year in conjunction with Plexus Group of Santa Monica, CA.

Other electronic marketplaces may be in the works. The big four Japanese brokers -- Nomura Securities, Daiwa Securities, Yamaichi Securities and Nikko Securities -- are studying the possibility of building a crossing network, sources say.

While their systems operate differently, both Instinet and Jefferies are trying to provide institutions with a way to avoid the market impact and commission costs of exchange trading. By removing the market maker or specialist, computerized crossing eliminates the spread between the bid and offer quotes.

But it remains to be seen whether these computerized systems can generate enough liquidity to become an alternative to the exchanges.

In the 1960s, networks such as Instinet were created to bypass the fixed commission structure of the New York Stock Exchange.

Today, the development of electronic marketplaces is being fueled by pension plan sponsors' concern about trading costs and by the rise in passive investing. Instead of trying to beat the market, many money managers are structuring their portfolios to mimic the market.

Passive investing has given birth to a number of strategies requiring entire portfolios to be traded in a single transaction. A manager may want to lock in the spread between stock index futures and the underlying equities or he may want to limit the equity exposure of his portfolio through asset allocation.

Observers say electronic marketplaces such as POSIT and the Crossing Network are well-suited to these so-called "informationless" trades.

"Packaged trades seem ideal for crosses," says Steve Wunsch, vice president at Kidder Peabody & Co. "There is a great deal of flexibility about when they come to market so there is plenty of time to find the other side of the trade."

Although commissions paid by institutional investors amount to just pennies a share, they add up when multiplied by hundreds of thousands of shares. Both the Crossing Network and POSIT charge just $.01/share for simple crosses.

In addition to commissions, fund managers face sizeable market impact costs when trading baskets of stock. At a recent Institute for International Research conference, Sheldon Johnson of Morgan Stanley & Co. estimated that an institution selling a $120 million portfolio made up of the issues in the Standard & Poor's 500 index would pay $520,000 in market impact costs.

With approximately $200 billion in pension fund assets currently indexed to the S&P 500 and other broad market measures, it's easy to see why institutional investors are taking a close look at electronic marketplaces for crossing equity trades.

POSIT will probably have a universe of 70 to 100 customers, says Don Luskin, senior vice president sat Jefferies. Of these, 30 will form a core group of active participants.

Although the Crossing Network got off to a slow start, it has been trading several hundred thousand shares almost every day since June, says Wayne Wagner, partner in Plexus Group. About 30 institutional investors have executed transactions over the network since its inception, he says, and another 30 are expected to participate in the system.

Both POSIT and the Crossing Network provide their customers with software that runs on an IBM PC so they can assemble lists of stocks and enter instructions about how their orders should be handled. Orders are transmitted over a dial-up modem.

The Crossing Network operates on the same "call to market" principle used by the European bourses, where all business is conducted at a specified time, instead of being spread throughout the day.

Participants in the Crossing Network begin entering the list of securities they want to buy or sell at 4:30 p.m., a half-hour after the securities markets close.

The system stops accepting orders at 5 p.m. and the Crossing Network's VAX computers begin matching trades. About 15 minutes later, investors log back on and find out which securities they were able to buy or sell.

All transactions on the Crossing Network take place at NYSE closing prices. If an investor's order is not filled, it is automatically cancelled and can be re-entered the following day.

"We give you an opportunity to finish what you didn't do today or to start what you are going to do tomorrow," says Wagner, who points out that no other securities markets are open for business from 4:30 to 5 p.m. Eastern time.

Instinet's traditional electronic execution system differs from the Crossing Network in that it is a continuous market where participants are able to negotiate prices. Wagner says it is possible an interface will be developed between the Crossing Network and Instinet, but right now market participants want the two systems kept separate.

In contrast to the Crossing Network, POSIT will operate from 7 a.m. to 7 p.m. Eastern time. When participants enter their list of securities, they can select the time at which prices will be determined by the primary market -- either the NYSE or the National Association of Securities Dealers Automated Quotation system.

Unlike the Crossing Network, POSIT is geared to executing the portion of a portfolio that cannot be paired off by computer. This unmatched residual will be executed by Jefferies on either an agency or principal basis. POSIT also allows investors to keep orders in the system or cancel them.

While both the Crossing Network and POSIT are aimed at institutional investors, they appear to be going after different sectors of the market.

The Crossing Network has been positioned as a way to reduce commissions and eliminate market impact costs. "The cost of trading is a detriment to performance," says Wagner. "There is much evidence that plan sponsors are not satisfied with the current method of trading."

By contrast, Luskin bills POSIT as "a marketplace for trading composite assets," and says it represents the latest step in the evolution of the securities markets.

The rapid growth of stock index futures since their introduction in 1982 and the popularity of program trading -- estimated to account for 25% of NYSE volume -- proves that investors want to trade composite assets, Luskin says.

However, index futures and program trading are both subject to frontrunning -- where a broker profits from the knowledge that a large order is coming to market.

POSIT and the Crossing Network say they can prevent such abuses by allowing participants to specify that no information about an order will be revealed to anyone until after it is executed.

The idea of a marketplace that would allow portfolios to be traded as single units has been kicking around the academic community for some time. Professor Hans Stoll of Vanderbilt University believes that some of the stock market gyrations caused by index arbitrage occur because the NYSE was designed to handle shares, not baskets of stock.

"Crossing networks have been created because the exchanges have not met the industry's needs," says Kidder Peabody's Wunsch. However, he says that if the exchanges lost business to electronic marketplaces such as the Crossing Network or POSIT, they could react very quickly.

Both Wunsch and Luskin also point out that off-exchange futures contracts or exchange for physical (EFP) transactions in index futures could be used as substitutes for crossing networks. The prices for EFPs are negotiated between two parties away from the futures trading pit.

Some question whether it is fair for the electronic networks to obtain prices from the exchanges when information about the crosses is limited to the parties to the trade.

But Instinet President Murray Finebaum says there is no difference between a newspaper printing stock prices and the Crossing Network using NYSE closing prices for its transactions. "Fifteen minutes after a quote is out, it is public information," Finebaum says.