A block trade is the purchase and sale of large volumes of financial securities between two parties. This commonly involves a large number of equities, such as stocks or bonds. Usually, these transactions occur outside the normal public markets. Block trades are executed through a discreetly negotiated trading platform like dark pools. This allows both parties in each transaction to freely trade large blocks of securities without influencing their price.
These trades are conducted beyond the regular exchanges to prevent abrupt price fluctuations, and also to avoid any temporary impact on the price of certain securities.
How block trades are executed?
Since a block trade involves a large number of securities being traded on the market, this trading process is often reserved for institutional investors. These large financial institutions have to conduct block trades through private exchanges. So they use either dark pools or block houses to execute these trades.
These are third-party intermediary firms that focus solely on executing block trades, for institutional investors. They specialize in arranging massive trades without deliberately causing price volatility in securities.
Through a number of these intermediaries, block trades can be bought and sold. The intermediaries guarantee that they will execute the trades at the best possible price. Once an order is placed, brokers at block houses will get in touch with other brokers, to try to fill the order as fast as possible.
What happens when a block trade is too large?
When a block trade is too large, the intermediary conducting the transaction will divide a large order into smaller orders. This way it guarantees that the orders are filled, without affecting the price of securities. This also allows for the trade to be executed faster. This type of order is commonly described as an iceberg order.
The idea behind it is that when you see an iceberg you can only see the outer part, and it will be difficult if not impossible to see how long it stretches under the sea. The same happens with these large orders that are broken into smaller orders. As it allows the brokers to conceal the identity of the institution behind the trades, and the volume traded.
Advantages of using block trades
There are several advantages of using block trades, not only for institutional investors but also for retail investors. Here are some of the advantages of using block trades:
- It allows large financial institutions to conduct bilateral security exchanges without adversely influencing market prices.
- Block trades allow analysts to determine how institutional investors are pricing certain securities.
- It is useful in the event of a merger or acquisition (M&A) since some market participants can see at which levels a large number of stocks are trading. These prices indicate the rate at which the company's top shareholders are willing to sell their shares. However, when conducting block trading research, it should only include minor trades to prevent data skewing.
Disadvantages of using block trades
Although there are some clear advantages of using block trades, there are also some impactful disadvantages that affect several market participants.
- Brokers are asked to commit to a price and to try and execute the trade as fast as possible. However, this is more challenging than it sounds. A broker trying to unload a large block of securities at a predetermined price, without influencing the current price at which a security is trading is not an easy task. Any significant impact on the price of securities could pose a risk to the broker, who has committed to sell at a predetermined price. If they are unable to sell that security for that price they might be faced with a considerable loss. This also affects brokers’ capital, which ends up being held until a particular trade is completed. Additionally, it puts increasingly more pressure on the execution due and exposes brokers to more risk.
- Some market participants, like hedge funds and large institutional investors, might be able to pick up information on a large block trade. They might try to take advantage of this situation by exploiting the possible price fluctuations of the securities that are being traded.
Example of a block trade
Consider the case of a hedge fund that is selling 200,000 shares of a tiny company with a current market price of $20. It is a transaction involving $4M. Now let us consider the stock’s market cap is worth only a few hundred million dollars in total.
If the identical order is entered as a single market order, the prices will most likely be pushed down. Furthermore, because of the large size of the transaction and the presence of market-making, the order will be executed at increasingly lower prices.
As a result, the hedge fund will notice order slippage, and other market participants will pile on the short trade based on price movement, and the volume spike. Continuously driving stock prices down. To circumvent this, hedge funds frequently use the blockhouse, or dark pools to assist them in dividing up a huge volume of trading into smaller, more manageable chunks.
For example, in this case, 100 smaller blocks of 2,000 shares each can be created for $20 per share. To reduce overall market volatility, each divided block will be traded by a different broker. It also allows the hedge fund to create the illusion that there are more institutions placing the same trade. As it is indiscernible if it is one institution or several behind similar trades. In addition, instead of using the aforesaid option, any broker can negotiate a purchase agreement with any buyer who will remove all 200,000 shares off the open market.
There are significant advantages to using block trades, and it certainly helps to increase market efficiency across the board.
Market traders must take precautions when conducting block transactions on the open market. As there will be substantial changes in the volume of the transaction. Therefore it might influence the market value of the securities traded. As a result, these deals are typically made using intermediaries, rather than through an investment bank or hedge fund, which would ordinarily purchase assets for lesser sums.
The block trade must be conducted in private, such as by private chat, phone, or other technological methods. It must be a direct interaction between the parties or brokers. As a result, they are carried out outside of the public auction market, through block houses and dark pools.
Blockhouse acts as a middleman in these transactions. These are companies that specialize in block trading. They understand exactly how to properly conduct the trade so that there is no dramatic fall or rise in the price of securities.
Institutional investors use block trading on a constant basis. Due to the large impact, they could have on traditional equity and debt markets. In practice, these deals are conducted when institutional investors and hedge funds purchase or sell large amounts of securities. Through intermediaries such as investment banks and other financial institutions.
Image source: FT