Institutional investors rely on dealers to execute stock trades but suffer high trading costs on large and difficult trades. According to a new Report from Forrester Research, Inc. (Nasdaq: FORR), dealers will create equity trading communities to efficiently match large buyers and sellers of stock and allow them to actively and anonymously negotiate prices. As a result, investors will see trading costs reduced by one-half to two-thirds depending on their investment and trading strategy.

Although 40% of Nasdaq trades currently flow through electronic trading systems — including electronic communication networks (ECNs) — none of them completely meets investors’ trading requirements. Trading costs remain high because ECNs are designed for small trades — the system displays anonymous orders, but order price and size are visible to other traders. As a result, investors won’t risk displaying large orders. And even though the NYSE’s Institutional Express system will anonymously match orders, all orders must still go through a dealer — that can still trade ahead at the expense of investors.

“Institutional investors are frustrated with high trade execution costs for good reason,” said Todd Eyler, senior analyst at Forrester. “The difference in rates of return between the top 20% of mutual fund performers and the next 20% is 1.8% — roughly the average trading costs for an actively managed fund. But simply blaming dealers for the cost is naive — high trading costs are perpetuated by shrinking trade sizes, new regulations, and dealers having to call around for the best price.”

To reduce institutional investor equity trading costs, dealers must create equity trading communities — trusted networks of institutional investors that automatically match large buyers and sellers of stocks and allow for active, anonymous negations of price. Equity trading communities will make supply and demand visible to investors, match investors with complementary trading preferences, and allow investors to directly negotiate and set prices.

Today’s stock market is fragmented into seven exchanges, 12 ECNs, and 700 marketmakers — all with separate order books. Dealers typically show their three best prices to investors. But in an equity trading community, investors will see a complete view of supply and demand because dealers will open up their books.

Investors also get hit with market impact costs because information leaks into the marketplace before large trades are executed. In an equity trading community, large investors won’t join unless they know they are dealing with credible parties that can also make large trades. With the top 50 investors controlling two-thirds of all equity assets, dealers will create investor networks and limit membership to the largest investors. The trading communities will pull large orders from investors’ order management systems and directly match investors who have corresponding trading objectives.

“Equity trading communities will not spring up overnight,” added Eyler. “The largest dealers want to protect their lucrative marketmaking 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.”

For the Report “Reducing Equity Trading Costs,” Forrester interviewed 46 institutional investors and portfolio managers. Forrester found that 72% of the interviewees use electronic trading systems to lower trading costs.