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September 30, 2000

Merrin's Solution to Liquidity Problem: A Better Mousetrap To Crush Market Impact?

By Peter Chapman

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  • Merrin's Solution to Liquidity Problem: A Better Mousetrap To Crush Market Impact?
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Lupien got it wrong.

Will Merrin get it right?

Seth Merrin, the technology pioneer widely credited with launching the order management system industry, is now vowing to do what others tried but failed at: eliminate market impact on block trades.

Merrin's new venture, Liquidnet, hopes to provide access in one gigantic pool of orders, the liquidity in the OMSs at the top buy-side firms.

The plan: Traders using Liquidnet will be electronically notified when the system has the other sides of orders on their blotters. The traders would then have the option of negotiating the trades with their counterparties.

"We are creating a country club kind of network," said Merrin, chief executive of Liquidnet, a 30-person operation based in New York. "All the members have the same problem-huge orders they must execute."

"The market impact is killing them because right now brokers are the only way they know to match up with other institutions," he added. "Market impact is an enormous problem."

Merrin had a hit ten years ago when he introduced the Merrin Financial Trading Platform (now owned by The MacGregor Group). Since then the installed base of these order-tracking and routing devices has ballooned to some 700. All told, they account for an estimated one billion shares in order flow each day, according to the Tower Group, a securities consulting group in Needham, Mass.

Traders agree that market impact, or the effect of a large trade on the price of a stock, is a costly overhead. But while they like the Liquidnet concept, some foresee practical problems in using it. "They say it's a passive system, but in practice the trader is going to have to make adjustments everyday on his OMS, or else he is going to run into problems," said one trader familiar with Liquidnet.

The Liquidnet scheme has three parts. First, it plugs into the OMSs of the largest trading desks over the Internet and amalgamates all the orders. Second, it displays to traders select contra-orders to those in their OMSs. Finally, it lets traders negotiate price and quantity among themselves via text chat. No sales traders are involved so no information is leaked, Merrin says. That eliminates the possibility of market impact, he says.

Unlike other trading systems, there is no inputting or monitoring of orders. Finding the other side is a completely passive process on Liquidnet. Liquidity is brought to the trader. The trader does not have to bring liquidity to the system.

Traders never know with whom they are dealing. They also do not know the total amount of the stock available for sale. They only know there is enough to at least match a predetermined minimum portion of their order.

Minimum quantities negotiated are based on parameters established by traders when they first connect to the system. A trader might specify he will only accept contras with at least 25 percent of his order. That way a buyer of one million shares, for example, would be dealing with a seller of at least 250,000 shares, if at all. (A million-share buyer would normally not want to deal with a 5,000-share seller.)