CutterAdvantEdge

Issue 66, April 2009

The Current State of Trading Technology and The Search For Liquidity: An Interview with Seth Merrin

Mark Bobseine, Founder and Chairman of Cutter Associates, recently had an opportunity to catch up with Seth Merrin, co-founder and CEO of Liquidnet, to hear his views on how buy-side trading is changing due to current market conditions.

Bobseine: How has trading changed since Lehman's collapse?

Merrin: The bankruptcy of Lehman Brothers forced institutions to revisit their trading strategies. The end result was a discernible flight to quality away from the broker dealers who are viewed to be in financial trouble. In addition, many of the bulge bracket analysts, traders, and relationship managers are leaving to join smaller firms. Today, institutions are focused on engaging in trading activities with firms that do not have the leverage and financial exposure that have plagued some of the largest players in the financial space. The mid-tier brokers are gaining share at the expense of the larger brokers.

If you had asked six months ago what would have to happen for Liquidnet to be viewed as a safer counterparty than the bulge bracket firms, we wouldn’t have had an answer. Today Liquidnet is gaining market share as the financial collapse has further exposed the key benefits of our business model.

As a result of all of the turmoil in the markets, the notion in many quarters that “independent” is synonymous with “boutique and lacking breadth” has changed. “Independent” is now viewed as “safe and secure,” which is what every trader is looking for in today’s environment.

Bobseine: How does Liquidnet deal with the lower volume, higher volatility market?

Merrin: Liquidnet’s product offerings have grown to encompass strategies that Members can use for every type of trading.

Generally, when volume growth slows or declines, sourcing liquidity becomes more difficult and trading large blocks amongst our community of like-minded, buy-side only investors is even more attractive. In periods of extremely high volatility, our strategies provide our Members with the controls over how and when to access our unique liquidity pool of over 10 billion shares per day. The difference with Liquidnet is simple—it is about liquidity and exclusivity. We provide our Members with access to more liquidity than the five U.S. exchanges combined, and when our Members create orders, 96% of the time they have no competition. In essence, they own all that liquidity, as opposed to competing for every 200 shares traded in other venues.

Bobseine: What is your perspective on algorithmic trading?

Merrin: Algorithms are only as good as the liquidity they can access. Algorithms were created for the sole purpose of taking large institutional orders and chopping them into pieces to execute in a market where the average execution size is 300 shares. Because of the way most algos are set up, and the fragmentation that exists in the market today, trading with them is dictated by when liquidity becomes available. Therefore, you are competing with everyone else in the market. The algos will compensate for this by “spraying” the market with multiple cuts of the same order. This often results in the same order chasing liquidity from venue to venue—or worse, competing against itself.

At Liquidnet, our Supernatural strategies have a distinct advantage in that they are able to tap into two unique liquidity sources: our 2.1 billion shares in our natural pool and 8.9 billion shares in Liquidnet H2O. Through these two pools alone, our Members can access more liquidity than the total volume in the top five U.S. exchanges combined. In fact, 96% of the time, our Members have absolutely no competition for the liquidity that they are seeking.

Bobseine: What should the buy side expect from liquidity technology in 2010?

Merrin: There will be differentiation between institutional marketplaces and the retail marketplace, and the institutional landscape will be divided between those that route to find liquidity and those that are execution destinations. The unknown factor is how much liquidity can be aggregated into the execution destinations and how efficient the institutional trading market will become with better technology and more centralized institutional liquidity.

The buy side should expect to focus on aggregating liquidity, not chasing it; and that is what we deliver. That is the business model that will succeed in 2010, and beyond.

Seth Merrin is co-founder and CEO of Liquidnet Holdings, an electronic marketplace that facilitates institutional equities trading for more than 550 asset management firms worldwide, with trading in 29 markets across the globe. He has served as its President and Chief Executive Officer since November 1999. Prior to Liquidnet, Seth co-founded VIE Systems, Inc., a financial services application integration software company, in 1997. In 1985, Seth founded his first company, Merrin Financial, which launched the industry’s first order management, compliance, and electronic order routing systems for asset managers. Merrin Financial was sold to ADP in 1996.