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Trading Technology

12:40 PM
Andrew Rafalaf
Andrew Rafalaf
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The Second Coming of Merrin

Will LiquidNet Succeed Where Others Have Failed?

"Why are we different? Our box is a decentralized, passive system. Rather than create this central book that anybody can look at, we want to provide a very comfortable environment for buy-side traders to disseminate and receive indications of liquidity." Seth Merrin is pitching his pitch, the same one he has given to 80 buy-side firms, the one he will deliver to another 50 before December. Merrin's back, this time with a new institutional alternative trading system, and he wants you to know it in a big way. "I don't know, you could say a new sheriff's in town."

Seth Merrin, if perchance you've been sitting in a closet for the past 10 years, is the individual who single-handedly ushered in the buy-side electronic trade-order management industry with the Merrin Financial Trading System. After selling Merrin to ADP, he jetted off to the West Coast for some time, invested in and ran a company that developed publish/subscribe technology for the healthcare industry, cashed out and returned to NYC with that publish/subscribe protocol in hand and a clipboard full of ideas in the other. Whereas he once spawned an entire industry, this time he's looking to ostensibly create a new fourth market, one that doesn't include marketmakers and the market impact that comes with them.

LiquidNet, as the project has been dubbed, stands to be a distributed, institutional liquidity environment. That's right, no central order book from which competitors can make decisions. In its purest form, LiquidNet will integrate with a firm's order management system, and a small window will sit aside the main trading screen. The ATS is, therefore, "plugged in" and has potential access to all the liquidity sitting on the desks of its participants. If a trader is looking for a half-million shares of IBM, LiquidNet will "ping" all the other systems on the network and return with a message saying, yes, there are a number of possible sellers. No names are given, no specific amount of shares divulged.It is also a passive system in that it requires no added work from the trader. There are no extra screens to look at, no orders need be entered. LiquidNet only assures the possibility of a trade, which can then be conducted if the involved parties decide to conduct an electronic conversation.

The main intention behind LiquidNet is that institutions be able to do large block trades with as little market impact as possible. Any existing venue, whether it be a broker and its many intermediaries or Instinet and its legion of "talkative" traders, increases the number of possible people that know about a large trade, in turn affecting the price at which an institution will be able to buy or sell. As it stands today, you can be sure that if Fidelity is looking to sell a million shares of IBM, they are not the only ones on the Street who know about it.

LiquidNet is not the first to attempt to solve this problem. No discussion about a new alternative trading system would be complete if it didn't address Optimark, the big idea that could. Optimark, hailed by all industry participants as "the next big thing" only three years ago, has failed to capitalize on its intended success. Currently, many institutions have dropped the system, and those that use it do so in a limited fashion.

Like Seth, Bill Lupien, chairman of Optimark, is a titan in his industry. Credited for turning Instinet from a trading backwater into the ECN behemoth that it is today, Lupien had the passion and the market insight to ensure Optimark's success. And, yet, by most accounts, it has proven a failure. Whether Optimark can rebound is anyone's guess. It is difficult to deny the past tense that everyone uses when speaking about the system: "was" is used in lieu of "is" and "did" versus "does." The people who believe it has failed will add in the same breath that they won't count out a future rebirth. Yet, the fact today is that it is a marvelous technology that is sitting and collecting dust. Where did Optimark go wrong? Merrin believes he has the answers to that question, answers that have lead to the formation of LiquidNet. Aside from the reasons people sight as Optimark's shortcomings, there are those who believe market forces—the engendered relationship between the buy and sell side—will make it difficult for any alternative trading system to succeed. As you may have guessed, Merrin believes LiquidNet takes those issues into account as well.

Optimark Trips and Stumbles

Merrin's pitch is peppered with references to Optimark, as well as Instinet and Posit, but undeniably Optimark is the springboard for this initiative. "One of the things that Optimark proved was the absolute need and the absolute desire to do something like this," Merrin said. "They just went about it in the absolute wrong way."

Optimark would agree. Speaking about its early missteps and what it has done to recover, Bob Colgan, president of U.S. Equities at Optimark, believes that the system would have been better served had it marketed itself as a simple crossing network, and then, later, trumpeted the system's more advanced features. "We started with the end product instead of starting with a more simplistic product," Colgan says. "We should have made it easier from the beginning and built complexity into it as the users built their knowledge. That's what we're correcting now."

And ease of use, or a lack of it, was the first strike against Optimark. The system employs very complex "satisfaction profiles" where traders can determine at what prices they are willing to execute what amount of shares. At $50 and a quarter they may be willing to purchase 1000 shares, but at $50 they will buy 50,000 shares. This sounds like a good idea at first glance, but it was very tedious for traders to master and then use.

"The one reason that stands out above all others why Optimark failed was its ease of use, or lack thereof," remarks Preston Ford, founder of the Longview Group and currently chief strategist for TenFold Investment Management Group. "You needed to input the equivalent of a short doctoral thesis for these trades."

This difficulty—or perceived difficulty—turned traders away in droves. "Optimark, simply, was hard to use. It required a huge effort and, at the end of the day, there might not be a match on the other side," points out Mark Bobseine, CEO of industry consultants Cutter Associates. "So you went through a lot of work for nothing."

Merrin believes that LiquidNet provides the exact opposite: a trading environment that requires no extra effort on behalf of the trader. Unlike Optimark or Instinet or Posit, what are deemed proactive systems, LiquidNet will not require a trader to enter in orders to find out what liquidity resides on the system. Since it will rest atop the order management system, LiquidNet will "know" what volume all the participants intend to trade. Users can program the system to query all participants that meet a certain requirements. For example, if someone is looking to sell a million shares of IBM, they may ask LiquidNet to find all those counterparties that have at least 20%, or 200,000 shares, to buy. The LiquidNet applet sitting on the OMS will announce that there are X number potential buyers, and the trader can then begin an electronic dialogue with a counterparty. It is at that point that the two traders discuss and decide upon an acceptable price. Merrin anticipates that buyers and sellers will typically agree on the midpoint between the current bid and offer.

"The nicest thing about this is that the trader doesn't have to do anything," Bobseine points out. "The trader can act upon the ping, so to speak, and then can then decide whether to buy or sell."

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