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June 6, 2006

Who's Afraid of the Dark?

By Nina Mehta

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  • Who's Afraid of the Dark?

Merrill Lynch's announcement last month that it would partner with competitor Investment Technology Group in an electronic crossing venture underscores the frenzy taking place in Wall Street's major equities houses to deliver crossing systems to their institutional customers. The deal, which marries Merrill's voluminous order flow with ITG's trusted crossing technology, puts Merrill on similar footing with Goldman Sachs, Credit Suisse, Morgan Stanley and others.

All the majors are scrambling to put up systems that they hope will cut their costs, earn them more of the commission pie and win back business now headed to a small group of specialty brokers.

Merrill makes no bones about the benefits of teaming with ITG. "The existing liquidity pool through the Posit system allows us to jumpstart this quickly, so the time to market is rapid," notes Rohit D'Souza, global head of equities at Merrill.

Within these systems, many of which are registered with the Securities and Exchange Commission as alternative trading systems, brokers can cross order flow from various silos, including customer agency orders, principal orders, retail and institutional flow, correspondent clearing business and so on.

Internal crossing networks are often called dark liquidity pools. That's because they don't display quotes to the market. Orders are matched internally according to a black-box matching engine and offer price improvement over the national best bid or offer.

Buyside Blues

Currently, one of the buyside's big problems is the difficulty in transacting institutional-sized orders with limited market impact. Information leakage and decimalization make it costly for investment managers, pension funds and others to execute large trades. Therefore, buyside traders have been turning in droves to the crossing systems of specialty brokers such as Liquidnet, open only to buyside institutions, ITG, Pipeline and NYFIX.

These systems, when they're successful, quickly match up large orders and with minimal market impact. Consequently, they've snatched large chunks of order flow from traditional market centers as well as bulge-bracket firms. This is a trend that shows no sign of abating.

"It's a natural progression for broker-dealers moving from traditional brokerage to electronic brokerage to be more efficient in how they handle block trades," says ITG's Chris Heckman, co-head of the institutional broker's trading desk. "Hence the creation of their own internal crossing systems."

Merrill acknowledges as much. "Self-directed customers are already interacting with each other. This is a way for us to step back into a place where we are being disintermediated," says Mike Stewart, global head of cash equities at Merrill Lynch.

For the largest brokers, an internal crossing system is fast becoming a necessary product in the electronic trading suite they must offer clients. "It's one leg the spider stands on," says Chris Morstatt, a partner at research firm Tabb Group. He stresses that internalization, broadly viewed, has a number of features. These include market making, positioning and matching orders all the way to direct market access. "These are all different ways to execute, which minimize the execution costs to the broker and maximize the value of each order," Morstatt adds.

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