Institutional investors who conduct large stock trades, such as mutual funds, will force dealers to create equity trading communities to lower trading costs by 2003, according to a new report by Forrester Research of Cambridge, Mass. As a result, investors will see trading costs cut by between one-half and two-thirds, according to the report.

Currently, 40 percent of Nasdaq trades flow through electronic communication networks, according to Forrester. However, these ECNs are designed for smaller trades since order price and size are available to other investors, and investors will not risk displaying large orders. The New York Stock Exchange uses a system called Institutional Express to handle large orders by matching orders anonymously, however they must still go through a dealer, who could trade ahead and hurt those investors, according to Forrester.

Because of that, dealers will be forced to create equity trading communities, networks of institutional investors that automatically match buyers and sellers and allow for anonymous price negotiation with other investors in the network, according to Forrester. Large sellers would be matched with large buyers and institutional-size orders would not have to be released to the public.

The movement towards these types of networks is due to several forces that are converging on the marketplace, said Todd Eyler, senior analyst at Forrester. The first is that the market has reversed direction and therefore made trading costs much more relevant, he said. Also, trading costs are becoming much more transparent, especially with recent SEC rules forcing dealers to benchmark their trade execution performance, according to Eyler. Lastly, the emergence of ECNs and growing popularity of them will push dealers in that direction, he said.

"Equity trading communities will not spring up overnight,'' said Eyler. "The largest dealers want to protect their lucrative market making and equity trading business. But smaller dealers will aggressively adopt electronic trading approaches, stealing market share and forcing large dealers to create their own equity trading community by 2003."

The report is based on interviews with 46 institutional investors and portfolio managers.

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