When Napster threw the entertainment industry for a loop earlier this year, technology pundits hastened to point out that the free exchange of recorded music was a mere hint of the software’s revolutionary, disintermediating implications.
By Jeffrey Kutler
November 2000
Institutional Investor Magazine
When Napster threw the entertainment industry for a loop earlier this year, technology pundits hastened to point out that the free exchange of recorded music was a mere hint of the software’s revolutionary, disintermediating implications. Some talked about the toppling of old business and distribution models for books, films, software and other digital goods. Now a similar brand of peer-to-peer computing is set to explode on Wall Street.
In January a system called Liquidnet is scheduled to begin working Napster-like magic with large equity trades. If it overcomes the chicken-and-egg problem facing any such effort -- attracting enough participants and sufficient liquidity to avoid the price gyrations known as market impact -- then Liquidnet could become the institutional equivalent of electronic communications networks. Unlike Instinet and other ECNs, Liquidnet would cater specifically to buy-side institutions and their large transactions. Trading would be anonymous and completely automated.
“ECNs do what they do well,” says Liquidnet CEO and Wall Street technology veteran Seth Merrin. But they don’t address the inefficiency problem that he estimates costs the 100 largest asset management firms $70 billion a year in market impact alone. Three fourths of in-
stitutional orders are for 250,000 or more shares, up from 20 percent five years ago, according to Plexus Group research. In the mix with the Internet-fueled mass of retail trades -- the average on Nasdaq is for 700 shares -- institutional liquidity suffers.
“Institutions are doing millions of shares a day, and their transaction costs are out of line,” says Merrin, 40, who made his first mark in the 1980s with Merrin Financial, an originator of buy-side or-
der management systems that he later sold to Automatic Data Processing. He is banking on a simple peer-to-peer design, with computing power distributed among the buy-side traders. “Pings” over the network would signal potential order matches. Counterparties would negotiate sales directly, with Liquidnet serving as a transaction-only broker, its commissions one third the norm, says Merrin. “Institutions need liquidity, not research, which is being commoditized,” he adds. “This is about giving institutions what they need today -- not what they needed 20 years ago.”
Merrin has a controlling interest in New Yorkbased Liquidnet. He got venture capital from TH Lee.Putnam Internet Partners, and his directors, also investors, include Michael Price of Franklin Mutual Series fame and Neuberger Berman managing principal Lawrence Zicklin.
Some 150 firms with $5 trillion in total managed assets have committed to Liquidnet. It is unclear how soon or how much they will use the system. But a rival, Optimark, retreated in September after conceding that its institutional network was too hard to use -- and sell. Says Merrin: “We look like a white knight. This is now ours to lose.”
That said, Liquidnet faces obstacles. Lower costs may be alluring, but firms, says analyst Gary Craft of Financial- DNA.com in San Francisco, “will still need ways to pay the source that feeds them -- research and access to IPOs.” Dana Stiffler, who follows alternative trading systems for Meridien Research in Newton, Massachusetts, finds the technology intriguing but raises security concerns. “These massive transactions will be a huge attraction for hackers,” she warns.
Says Gary McAnly of Pacific Investment Management Co., one of several chief traders advising Liquidnet: “I’d support any system that can provide additional liquidity to the firm. If you deal with the security and if the system is really electronic and anonymous, then I’d have to take a look at it.”
