Because the increase in institutional trading has caused an increase in block trades, it is important to consider how block trades influence the market and understand how they are transacted. The increase in block trading by institutions has strained the specialist system because some specialists did not have the capital needed to acquire blocks of 10,000 or 20,000 shares. Also, because of Rule 113, specialists were not allowed to directly contact institutions to offer a block brought by another institution. Therefore, specialists were cut off from the major source of demand for blocks. Block Houses This lack of capital and contacts by specialists on the exchange created a vacuum in block trading that resulted in the development of block houses. Block houses are investment firms (also referred to as upstairs traders because they are away from the exchange floor) that help institutions locate other institutions interested in buying or selling blocks of stock. A good block house has (1) the capital required to position a large block, (2) the willingness to commit this capital to a block transaction, and (3) contacts among institutions.
Example of a Block Trade: Assume a mutual fund decides to sell 50,000 of its 250,000 shares of Ford Motors. The fund decides to do it through Goldman Sachs (GS), a large block house and lead underwriter for Ford that knows institutions interested in the stock. After being contacted by the fund, the traders at Goldman Sachs contact several institutions that own Ford to see if any of them want to add to their position and to determine their bids. Assume that the previous sale of Ford on the NYSE was at 35.75 and GS receives commitments from four different institutions for a total of 40,000 shares at an average price of 35.65. Goldman Sachs returns to the mutual fund and bids 35.50 minus a negotiated commission for the total 50,000 shares. Assuming the fund accepts the bid, Goldman Sachs now owns the block and immediately sells 40,000 shares to the four institutions that made prior commitments. It also “positions” 10,000 shares; that is, it owns the 10,000 shares and must eventually sell them at the best price possible. Because GS is a member of the NYSE, the block will be processed (“crossed”) on the exchange as one transaction of 50,000 shares at 35.50. The specialist on the NYSE might take some of the stock to fill limit orders on the book at prices between 35.50 and 35.75.
For working on this trade, GS receives a negotiated commission, but it has committed almost $ 355,000 to position the 10,000 shares. The major risk to GS is the possibility of a subsequent price change on the 10,000 shares. If it can sell the 10,000 shares for 35.50 or more, it will just about break even on the position and have the commission as income. If the price of the stock weakens, GS may have to sell the position at 35.25 and take a loss on it of about $ 2,500, offsetting the income from the commission. This example indicates the importance of institutional contacts, capital to position a portion of the block, and willingness to commit that capital to the block trade. Without all three, the transaction would not take place.
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