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Merrin Decides to Swim with the Sharks

Online block-trading network Liquidnet has enjoyed huge success by offering institutional investors a safe haven: It has been closed to brokerage firms, exchange floor traders and other fast-money players who might want to profit from knowing buy-side firms' intentions.

Online block-trading network Liquidnet has enjoyed huge success by offering institutional investors a safe haven: It has been closed to brokerage firms, exchange floor traders and other fast-money players who might want to profit from knowing buy-side firms' intentions. Now Liquidnet is letting the sharks into the water.

The six-year-old company is introducing a new way for its 350 buy-side members to trade. Dubbed H2O, the system allows small orders from brokerage firms to pass through Liquidnet on their way to execution on Nasdaq, the New York Stock Exchange and other platforms. Traditionally, Liquidnet members have negotiated deals with one another for hundreds of thousands or even millions of shares after the network has alerted them to potential partners. Now they'll be able to expose a portion of their trading interest to H2O's stream of retail-size liquidity. Whenever an order coursing through that stream is for a stock that a Liquidnet member has chosen to trade using H2O, the online network executes it at the midpoint of the bid-offer spread, guaranteeing the brokerage firm order a better price than it otherwise would have received.

"Institutional orders represent a majority of the shares traded, but they have to go to an exchange where the supply is broken up into 400-share increments," points out Liquidnet CEO Seth Merrin, citing the average size of Nasdaq and NYSE trades today. "The significance of H20 is, the supply now comes to us. We're fixing the imbalance, and that's enormous for this industry."

Merrin, 45, hopes his creation will siphon trades from rivals and thereby help sustain Liquidnet's spectacular growth: Its average daily volume, now 44 million shares, is rising at a rate of about 50 percent per year. Last month the firm announced that nine brokerage houses -- including Goldman Sachs Execution & Clearing and Piper Jaffray -- had signed on as "streaming liquidity providers" for the new system. Deals with several more firms are in the works, Merrin says.

Yet H2O risks alienating members who embraced Liquidnet precisely because it excluded the sell side. Mindful of this, the company has taken pains while developing H2O to ensure that brokers won't be able to see or actively engage members' orders. Sell-side orders can pass through only after the brokers' algorithmic trading systems have sent them off to be executed someplace else. And H2O trades will be printed in the third market so that the confirmation reports don't give away that Liquidnet was the venue.

Nevertheless, traders speculate that the system, which has been in development for more than two years, can probably be gamed. Professionals at the liquidity-providing brokerages, for instance, might look for trades executed at half-cent increments as a sign that H2O was involved. That's because most trades in the wider stock market are executed at whole-cent price increments. Liquidnet's midpoint executions are struck at prices including half cents whenever the spread is one, three or another odd number of cents.

"If someone sitting on one of these algorithmic desks sees a half-penny print, they can bet that there's lots more behind it and start trading on that information," says one brokerage firm executive familiar with H2O.

Merrin acknowledges that brokers might try to outfox the system -- and that they might succeed once in a while. "Nothing is foolproof," he says. But he's confident that such instances can be kept to a harmless minimum. Liquidnet has the power, he notes, to force a brokerage to exclude certain of its customers' orders from the stream. Furthermore, several alternative exchanges and trading systems now in development plan to offer midpoint pricing (see "ISE's Krell exercises a strategic option," page 13). In time, that should limit traders' ability to guess when H2O has executed a trade, he says. Most important, adds Merrin -- who cut his teeth on Wall Street as a risk arbitrage trader for Oppenheimer & Co. -- the new product's growth potential outweighs any downside from changing Liquidnet's buy-side-only strategy.

"Our job is to give our members as much liquidity as possible, and then more ways to access it," he says. "Obviously, we want to continue to grow the business."