By: Rob Hegarty, Vice President, Securities & Investments, TowerGroup

While there are many interesting and exciting changes taking place in the securities and investments industry (e.g., the data management boom, the use of new asset classes such as derivatives, the globalization of the industry, etc.), perhaps none is more drastic - and, at the same time, more expected - than the changes taking place in the electronic equity trading arena. In one fell swoop, the debate around consolidation of the ECN space was silenced. On April 22 - two days after the NYSE and ARCAEx announced their merger - Nasdaq announced its plans to acquire INET. And with that move, the future of U.S. equity markets was settled ... or was it?

Yes, it's true that the ECN space doesn't even exist anymore (all right, at least it won't in the next couple of years). But the battle for market share in electronic trading is far from over. The next battle ground for U.S. equities will take place right on your block - for the block trade. In a world dominated by just a few players (Liquidnet, POSIT, Pipeline and some others), these anonymous, electronic block trading systems now will become the primary focus for growth opportunities in trading. Although combined these systems currently account for less than 2 percent of total U.S. equity trading volume, the upside potential is enormous.

As buy-side firms struggle to execute the ever-increasing-size block trades, amid the proliferation of small-order ECNs, the attraction of these systems becomes more apparent. When combined with the declining competition for the small orders (manifested by the mergers of NYSE/ARCAEx and Nasdaq/INET), the ability to execute large block orders electronically and anonymously becomes infinitely more important.

The model of trading large blocks electronically and anonymously has been validated by Liquidnet's success. However, they only have scratched the surface of the potential for this market. It is no secret that large institutions would prefer to execute their block trades in as few individual executions as possible, reducing market impact as well as the time it takes to complete a trade. Given these assumptions, one can expect to see a significant increase in the volume of shares traded on large-block systems.

While Liquidnet's success demonstrates the potential for growth in the electronic block business, POSIT's declining market share illustrates the shifting demand by traders to trade electronically. As shown in Exhibit 1, Liquidnet has grown steadily over the last three years, partly at the expense of POSIT. As these systems mature, and the acceptance of them becomes greater, the continuous matching model of Liquidnet - so long as it has sufficient liquidity - is favored over the periodic auction model of POSIT.

The different models of POSIT and Liquidnet can be compared to throwing a party. If a goal of your party is to introduce people of like interests, you are more likely to have them run into each other if you define the times for your party (i.e., from 8 p.m. till midnight) rather than just declaring an "open house" all day. The party with the defined times can be compared to POSIT's auction model - you know when the crossing will occur at several times throughout the day. However, Liquidnet has become successful using its continuous crossing model, largely because it has garnered enough liquidity to hold an open house throughout the trading day. Therefore, once the liquidity in the Liquidnet model reaches critical mass, its continuous crossing becomes much more attractive - the chances of matching with the natural other side of the trade increase.

Going forward into 2006, expect to see the battle to achieve this critical mass of liquidity in the electronic large block systems heat up - to the point where the stalwarts become more aggressive and the upstarts shake up the status quo. Sound familiar?

Rob Hegarty is VP of the securities & investments practice ar TowerGroup, an advisory research and consulting firm focused on the global financial services industry. Hegarty's group focuses on technology trends and strategies in the brokerage, capital markets, investing and asset management industries.

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