With a few clicks of the mouse last August, 3.6 million shares of Sun Microsystems transferred from one institution to another. Large and instant, the trade was notable for what it lacked: a traditional trading desk. More than 1,000 similar trades occurred in a single day thanks to a firm called Liquidnet. And if the company is able to flourish despite significant challenges ahead, institutional power may consolidate further at the expense of Wall Street trading houses.
Launched five years ago, Liquidnet has helped transform the staid world of institutional trading and facilitate a movement away from classic trading desks. Combining technical innovation and market insight, founder Seth Merrin set out to circumvent traditional traders and catapult Liquidnet into the upper echelon of trading firms. Operating since 2001, the New York upstart reports a liquidity pool that averages 1.5 billion shares per day – the third largest in the U.S. behind the NYSE and Nasdaq.
Liquidnet’s fluidity in the market can be compared with Napster’s effect on the music industry: it was achieved by creating an electronic community where member firms trade directly with each other. This community – or private crossing network – has become a venue of choice for executing large block orders. Averaging more than 40,000 shares per execution, block trades on Liquidnet surpass those of rivals like the NYSE that average just below 30,000 shares.
“Part of the difficulty in block orders is finding liquidity,” noted Dennis Fox, head trader for Munder Capital Management.
Peter Kassimis, a former Liquidnet employee now with New York competitor Pipeline Trading Systems, explains the system’s popularity: “What drove the shift to Liquidnet was both innovative products and frustration with the exchanges,” he said. “Fund managers didn’t feel like they were getting treated fairly in terms of execution... Managers were pretty much at the boiling point and willing to trade anywhere off the floor.”
Relying on prior experience as a risk arbitrage trader at CIBC Oppenheimer, Merrin sought to solve this problem, designing the system exclusively for buyside institutions to resolve liquidity issues of traders like Fox. It works by allowing select members to bypass Wall Street and trade directly – with block orders matched anonymously and executed away from trading floor buzz.
The Computer Guru
The firm’s origins go back to Tufts University, where Merrin graduated in 1982 as a student with a rare word processor. In demand by schoolmates, Merrin realized the value of workplace computers and applied this technophilia to his first job as a CIBC trader. Labeled “the computer guru,” it was not long before Merrin coupled hands-on experience with technical expertise – what he refers to as the “intersection of technology and domain experience” – to influence the world of institutional trading.
Beginning in 1985, Merrin founded and sold two companies prior to Liquidnet: VIE Systems, a financial services application integration company and Merrin Financial, a pioneer in institutional OMS. During this period Merrin’s buyside clients exposed him to a fundamental flaw in the market: Institutions were finding it increasingly difficult to execute block trades discretely and efficiently in traditional markets.
Complex order handling rules and decimalization, which reduced liquidity by increasing incremental price points, in addition to market forces like risk aversion and declining commission rates, encouraged Wall Street to execute smaller trades. New York consultant Tabb Group reports that the average number of shares per trade has been reduced from 1,500 eight years ago to 400 today.
“If you look at average shares per trade it is obvious that it has become harder for the buyside to execute large blocks and Liquidnet came along to fix that,” says Adam Sussman of Tabb Group. “Order handling rules and decimalization were wins for retail and huge losses for the buyside.”
Intimate knowledge of the buyside made Liquidnet a sought after system, says Sussman. “Liquidnet is a tech company in one sense but really it was their insight into how market structure wasn’t working for the buyside institutions that made them such a success; they clearly filled an unmet need in marketplace.”
Indeed, Liquidnet’s accomplishments are often raised in the context of broader dissatisfaction with traditional trading desks, occasionally with the suggestion that the company is helming a sort of alternative assault on established systems.
“A lot of traders are rebelling to a certain degree by creating competition for the exchanges,” noted Sang Lee, managing partner of Boston advisory firm Aite Group.
Such a movement could be underfoot, if investments in regional exchanges and a proliferation of electronic systems are any indication. “I would agree with people who say that recent investments in the regional exchanges and alternative trading systems are largely in response to NYSE and Nasdaq consolidation,” said Michael Hayes, director at Boston order management systems vendor Charles River Development.
And like the regional exchanges in Philadelphia and Boston, which recently completed high profile financings, Liquidnet has profited from this trend – with two private equity firms buying a $250 million minority stake, the company’s total valuation is over $1 billion.
The new investors may be pleased: Liquidnet’s yearend volume increased for the eleventh consecutive quarter, averaging 35 million shares daily or 50 percent over the previous year. In November Institutional Investor named the company alongside Lehman Brothers, Merrill Lynch and Citigroup as a top-10 NYSE and Nasdaq trading firm – the only alternative trader among this white-shoe milieu.
“Anytime a new market is this successful in disrupting the status quo the established players are forced to react,” Rob Hegarty, managing director at Boston consultant TowerGroup, notes, adding that traditional brokers may not represent the biggest threat at the moment. “They have some insight and plenty of resources but they don’t have first mover advantage and are now up against a significant pool of liquidity. Seth really built up a beachhead with this”
Success In Simplicity
Executing a trade on Liquidnet, such as the 3.6 million shares of Sun Microsystems, is relatively straightforward. Proprietary software scans members’ order books and anonymously indicates potential matches between two traders. First appearing “passive,” if a trade interests a buyer she can designate it “active.” The seller is then notified of the active interest and both parties are relocated to a “negotiating window.” Essentially a chatroom for the two contras, this window consists of a sliding bar on which the seller makes an initial offer on price and minimum quantity. The buyer has 40 seconds to accept this trade or repeat the process with her own offer.
“Seth wanted the user manual to fit on the back of a business card,” said Franco, emphasizing the system’s simplicity. Aite Group’s Lee believes he may have succeeded. “When I saw Seth’s demo years ago I remember sitting there and thinking it looked so simple,” he recalled. “The demo only took five minutes – they usually take an hour.”
Simplicity was instrumental to getting Liquidnet off the ground, as Merrin had to first convince the OMS operators and their institutional clients to adopt a platform that “lacked both a track record and funding.” He took his pitch directly to the head traders.
“Seth came from the OMS space and understood how institutional traders actually thought about their desktops,” recalled Hayes of Charles River Development. “He understood the incredibly important role that the OMS plays for traders and knew that if he built his system around this it could work.”
But even more critical to this process, Merrin says, was hiring a group that could realize Liquidnet’s potential, because, as he points out, not only was Liquidnet taking the novel step of creating a community of buysiders but it was also seeking access to member firms’ order books - “essentially the most valuable piece of information on Wall Street.”
“At first most firms said no and weren’t too polite about it,” says Merrin. “We were able to get them around by solving their number one problem.”
Success has attracted the attention of established brokers and exchanges, as well as newer electronic competitors. “It was a lot easier when we were under the radar as this quiet little alternative trading system,” lamented Franco of the firm’s conspicuity. “The Institutional Investor ranking was a real slap in the face.”
The Road Ahead
The greatest challenge to Liquidnet may come from either a new generation of electronic trading systems or the exchanges themselves.
“If the NYSE wants to develop a crossing network, that could be a very competitive product with Liquidnet at least conceptually,” said Joe Gawronski, chief operating officer of trading firm Rosenblatt Securities. “The institutional world would be much more amenable to this and it wouldn’t have the volume ceiling that Liquidnet and other crossing networks seem to always hit.”
Gawronski explained that volume on crossing networks can be limited if institutional commission budgets are skewed toward paying for research and other “bundled” products offered by traditional brokers.
Tabb Group’s Sussman agrees, noting that competition with Liquidnet may be more direct now that the NYSE has purchased electronic trader Archipelago and begun Regulation National Market Structure implementation with its own hybrid market. “But in a sense,” he points out, “Nasdaq has already stepped in the game with intraday crosses.”
Announced in October, Nasdaq will be implementing this quarter intraday crosses that will compete directly with Liquidnet. The system is designed to promote block executions by offering anonymous trades at set prices during specified periods. “The product will match orders at the midpoint with minimal size requirements,” said Brian Hyndman, Nasdaq senior v.p.
“Liquidnet came up with an innovative way to get into the buyside blotter system but I suspect they have plateaued,” Hyndman added. “They have grown a lot in the past but I don’t see that pattern continuing. That being said, our customer base did ask us to develop our own crossing products.”
While the effect of Nasdaq’s intraday crosses remains to be seen, Hegarty notes another challenge could be more immediate: “The biggest threat to Liquidnet is that they get ‘out-Liquidnetted’ or that someone more innovative comes along and creates an even more liquid market.”
Merrin recognizes this possibility. “For someone coming after us,” he says, “I don’t suggest using our model or having less liquidity. The barrier to entry is really the size of the liquidity pool.”
Aite Group’s Lee suggests that such innovation may come from existing electronic trading firms like Pipeline, a firm that also specializes in anonymous block trades. But Kassimis, who joined Pipeline after he left Liquidnet, denies the two are in contention.
“I don’t see us as direct competitors with Liquidnet. The press definitely raises us in the same sentences but that has to do with our average execution size,” he says. “There is absolutely room for both of us within institutional trading. There is real value in block trades and there are only two venues where you can get that done.”
Despite offering similar products, Merrin and Kassimis prefer to view each more as partners – at least for the moment. Through their aggregate success, these companies have helped establish an institutional trend in block trading away from Wall Street desks.
“The reality is that traders need to execute and there is concern that we are moving toward a dualopoly with the NYSE and Nasdaq,” agreed Hegarty. “This drove the bulge and buyside firms to invest in the regionals and firms like Liquidnet.”
Ultimately Merrin’s vision for Liquidnet may be part of a larger movement from the status quo toward a more varied marketplace. This could eventually represent a real threat to established brokers and exchanges, as Lee points out.
“If a few like-minded companies decide to work together they can build another Archipelago on a rounding error,” he says.
But speaking with Merrin one senses that the secret to his success may be focusing on what he knows – technical innovation and market insight. Liquidnet H20, Merrin’s next product, attempts to address limitations brought by focusing on buyside institutions through the introduction of retail order flow. The new system will match unanswered block trades against an additional flow from yet-unnamed streaming liquidity providers such as Lava or Ameritrade.
This ambitious system, currently being rolled out, is fraught with reputational risk among the buyside as it may challenge the institutional community that Liquidnet has established. But Merrin is applying the same skills to Liquidnet H2O that made the original platform successful, so it should not be discounted.
“Can Liquidnet top their first innovation?” asked Lee. “That would be tough to accomplish: it was a very elegant solution to big problem. But do they need to? Maybe the NYSE will just buy them. Or maybe they’ll just buy the NYSE based on that last valuation.”