Claiming that exchanges are retreating from the highly competitive equities markets in search of fresh pastures, Seth Merrin, founder and CEO of buy-side block-trading venue Liquidnet, sees a chance for his firm to provide a new service to exchange members.
“It seems that liquidity is very portable. Exchanges have to create strategies to lure the liquidity back,” he said. In a keynote speech at the World Exchange Congress on 22 March, Merrin took the opportunity to chide exchanges for backing away from servicing the needs of institutional investors, and offered Liquidnet as a potential solution, saying, “By combining liquidity pools with the exchanges, we are presenting more investment opportunities for the more than $12.5 trillion in investable assets that our members – the institutional investment community – represent.”
To Liquidnet, which saw a total of US$439 billion principal traded in 2010, up from US$387 billion in 2009, the consolidation of traditional stock exchanges is a diversification strategy, specifically away from cash equities. This threatens to restrict the future services on offer to the buy-side, according to Merrin. “Deutsche Börse and NYSE Euronext, London Stock Exchange (LSE) and TMX, combined will have cash equity components that will be less than 20% of their revenues. As a smaller percentage of their revenues, how much resource are they going to allocate to it?” he said.
Deutsche Börse and NYSE Euronext agreed to merge on 15 February and would have been the world's largest exchange group by revenue in 2010, which combined would have been €4.1 billion (US$5.4 billion). The LSE and TMX, who announced their own merger just six days earlier would have had combined revenues of Â£1.027 billion (US$1.739 billion) in 2010. Both the LSE and Deutsche Börse have seen equities revenues fall over the last three years.
Arguing that revenues from institutional trading will only be a small part of that 20%, Merrin believes the mergers will leave his firm's members – buy-side institutional firms – without sufficient attention or investment. “That opens up a good opportunity for us to partner with the exchanges. If they don’t want to invest in this sector, if they can’t come up with new revenue streams, they don’t have to look at M&A for everything – partnerships can work as well,” he said. “Right now every investment banker is giving them advice as to who they should acquire or who should acquire them. I’m suggesting they should look at other alternatives and other constituencies, providing services that competitors cannot or will not. Let’s not give up on the equities space.”
In January, Liquidnet partnered with Swiss market operator SIX Group to offer its buy-side customers the option of interacting with sell-side block liquidity from the exchange's members. The link, which will launch in Q2 2011, matches trades at the mid-point price of the primary exchange, which the firm says typically results in a price improvement of between five and 20 basis points across markets. Merrin expects to announce more partnerships in the coming months as part of Liquidnet's growth strategy. “There is a glass ceiling for the amount of business that asset managers can do with an execution-only venue,” he acknowledged. “But as the world becomes more unbundled and commission sharing agreements proliferate that ceiling gets raised..”
The firm also intends to expand into new geographic markets. Liquidnet currently trades in 38 global markets, having launched equities trading in Slovenia, Poland, Estonia, Lithuania, Mexico, New Zealand, Israel and Malaysia in 2010. “So many developing markets are highly inefficient, specifically for institutional investors, that it costs the institution way too much in terms of performance to get into and out of position,” explained Merrin, citing central and eastern Europe, east Asia, India and Brazil as offering potential. “There are very fast-growing GDP nations where trading is a nightmare in terms of costs. Investors are looking outside of the developed markets to find the best opportunities for performance.”
The firm has also expanded its range of services in recent years. Andrew Geissler was recently hired to join the firm's equity capital markets and issuer services business, which provides issuers with insight into institutional perceptions and how their stock is trading through a view of aggregated investor sentiment and research.
When corporations buy back stock or sell more shares they have a fiduciary obligation to get the best price for their shareholders, who tend to supply or demand liquidity in institutional size. This makes the information that Liquidnet holds on market sentiment invaluable says Merrin.
“The opacity of the information that Wall Street does and does not share with its customers creates enormous spreads,” he said. “Information that is necessary to ensure a successful offering is: is the investor sentiment in the stock, positive or negative? Is there enough demand to make the offering successful? We can provide that. Right now they have to put a finger in the wind.”
Pressure and sentiment
Merrin admits to concerns for Liquidnet's business model arising from the growing political pressure on regulators to force liquidity back on to lit exchanges. “The US clearly delineates between different types of dark pool. Most dark pools are simply internalisation engines at the large broker or market-making firms,” he said. “They don’t provide anything above and beyond what is found on the public exchanges. Not price improvement, not size.”
In 2009 the SEC proposed that dark and lit alternative venues report their trades to the US consolidated tape in real time, with the venue identified, although an exemption for block trades of over US$200,000 was noted. In 2010 it further proposed the idea of a ”trade-at' rule, preventing a venue that did not display national best bid or offer (NBBO) from executing an order unless it was at a “significant” level of price improvement on the NBBO or alternatively it could route the order to a market on which the NBBO was displayed.
In Europe, as part of MiFID II, the European Commission is proposing that
broker dark pools would be recategorised as multilateral trading facilities if they exceeded a certain scale of business, or if they accepted external flow, which is expected to reduce the number of dark venues that buy-side firms can use. In addition, Kay Swinburne MEP released an ”own initiative' paper to the European Parliament in November 2010 in which she suggested putting a minimum order size limit on dark pools to drive smaller orders onto lit venues.
Merrin hopes other regulators will follow the lead of the US regulator, the Securities and Exchange Commission (SEC), by distinguishing between different types of trading venue, “We show we provide massive price improvement and the SEC have determined that any service provided that cannot be found on the public exchanges can continue to exist – it looks like there will be less regulation on us in the US than there has been before.”
He believes that there is an increasing openness around the world to try trading on alternative venues. “We have moved very far down that line in the US. The UK is advanced but the rest of Europe less so. Australia is pretty advanced but the rest of Asia-Pacific is still wed to the exchanges and VWAP-type models,” he said. “You can see our international business is hitting records every quarter.”