Liquidnet, the buyside-only dark pool that has built a business crossing block-size orders, is expanding its line-up of execution services. Starting later next month, some brokers will be able to send block orders to Liquidnet H2O, a sister pool integrated with Liquidnet’s main pool, enabling buysiders to execute against that upstairs liquidity.
The firm’s objective is to give buyside customers another option to find contra-side liquidity. “Our business model and the value we offer have not changed,” said Jay Biancamano, global head of marketplace at Liquidnet. “We’re not letting the sellside into Liquidnet and the sellside gets zero information, but we’re bringing firm block liquidity from the sellside to the buyside desktop.” The new product, called H2O Blocks, does not charge the sellside for executions.
Just as Liquidnet sources buyside liquidity sitting passively in blotters, enabling institutions to execute against one another, Biancamano said, H2O Blocks brings reserve liquidity sitting in algorithms to buyside traders’ desks. The firm is doing this, he said, because institutions on average match only about 15 percent of their flow against other institutions. “We created streaming liquidity providers in Liquidnet H2O to tap into that [sellside] flow,” he noted, “and now we’ve created H2O Blocks for customers who want to trade in size with flow at brokers.” SLPs, or what Liquidnet calls streaming liquidity providers, are mainly brokers who send smart-routed algorithmic flow into Liquidnet H2O for executions against institutions. Buyside firms typically use H2O to finish up orders after matches against other naturals.
Institutions executing in Liquidnet will be able to choose to interact with H2O Blocks liquidity, just as they currently choose whether or not they want to interact with SLP liquidity coming through Liquidnet H2O. Firms will see a different icon in their Liquidnet application for H2O Blocks than they do for Liquidnet institutions and H2O streaming liquidity. Liquidnet’s negotiated pool and Liquidnet H2O are separately registered alternative trading systems, but they’re integrated liquidity pools. Liquidnet has more than 570 buyside members.
This newest expansion is a big change for Liquidnet, which has repeatedly touted its buyside exclusivity as brokers rolled out ATSs to internalize their electronic and customer order flow. Liquidnet’s advantage, executives at the dark pool operator said, was that buyside firms could execute against other institutions, minimizing the leakage that could result from trading against the sellside and proprietary flow.
Laurie Berke, a principal at research firm TABB Group, notes that more than half of buyside firms say their ability to execute blocks is down from what it was a year ago. She thinks buyside traders will take a “close look” at H2O Blocks. “If it can be demonstrated that they can avail themselves of new sources of block liquidity without selling an option on their order to a broker, they’ll welcome the opportunity to see the flow,” she said.
Berke points out that buyside traders also value transparency. They want to know who’s in the dark pools they access. Since Liquidnet identifies orders in H2O Blocks through an icon, “a buyside trader can make a fully informed, eyes-wide-open decision about whether to trade or whether to pass,” she said.
Nanette Buziak, head of equity trading at ING Investment Management, said she’s glad to have another option to source block liquidity. “Particularly for high-alpha trades, H2O Blocks will be another tool my team can utilize to access what I hope will be sizable block liquidity,” she said. Who’s on the other side of a trade is always a worry, she added, but it’s the trader’s job to decide when and where to trade.
Liquidnet is rolling out H2O Blocks as the industry changes. Dark pools are more mainstream and Liquidnet faces more competition, from both other block pools and brokers’ ATSs that draw a variety of flow. Liquidnet’s average daily volume in February was 62.5 million shares (double-counted), compared with 69.8 million in February 2008. The industry’s consolidated volume rose more than 50 percent over that period.
Alfred Eskandar, global head of corporate strategy at Liquidnet, notes that dark pools appeal to different segments of the trading community, based on their aims, with block pools servicing a niche. “There are trades based on investment decisions, and trades based on arbitraging the market,” he said. “We don’t service the latter.” Eskandar said dark pools connected with market-making firms and those friendly to flow from automated market makers have probably gained the biggest portion of the increased market volume in recent months.
According to Eskandar, Liquidnet is now trying to “thread the needle” with H2O Blocks. “Our constituency is the buyside,” he said. “We’ve come up with a way that mitigates the information leakage in interactions with the sellside, but without eliminating the certainty of getting block executions.”
Liquidnet H2O’s SLPs will be the only brokers that can send orders into H2O Blocks. Currently, there are 26 SLPs, including most, but not all, of the major broker-dealers. H2O Blocks will roll out with a half-dozen SLPs, with more brought on in phases. These sellside orders must be smart-routed, as is the case with electronic streaming liquidity. Sellside firms cannot put block orders into H2O Blocks from high-touch desks. As a result, H2O Blocks will mainly be the reserve quantity of large algorithmic orders brokers are working.
To protect the buyside in these interactions, Biancamano said, brokers who want to execute blocks against Liquidnet’s institutions are subject to various restrictions. H2O Blocks orders must meet minimum size requirements, based on the stock’s 30-day average daily volume. A stock with an ADV of 5 million shares or higher, for instance, has a minimum size requirement of 100,000 shares, while an illiquid stock has a 10,000-share minimum. Sellside orders must be firm and must rest in H2O for two minutes. And unlike in Liquidnet’s traditional pool, there’s no price or size negotiation on these orders.
The buyside has the upper hand when it comes to executing against H2O blocks, Biancamano said. Buyside firms with block contra-side flow can see the presence of a sellside block order (although not the size of the order), and can choose to execute against it or simply stick with the buyside. The sellside firm, in contrast, does not know whether there’s a buyside contra in the system and only finds out about an execution after the fact. The buyside firm decides how many shares to execute. Institutions also get three-quarters of the spread.
Liquidnet declined to say how much of an increase in executed volume it expects to see as a result of H2O Blocks. But Eskandar said the firm hopes new products will exceed the success of previous offerings. In 2007, Liquidnet launched a new order type called Supernatural, which enables buyside firms to scoop up liquidity in Liquidnet and H2O, as well as go to the public markets. That order type now accounts for one-third of Liquidnet’s executed volume, with two-thirds of that volume crossed within Liquidnet.
Liquidnet rolled out an early prototype of H2O Blocks a year ago that was tested by about 25 buyside firms and three SLPs. Eskandar said the firm went back to the lab to fine-tune the product to make it easier to use and improve its overall functionality. Customers will begin to get H2O Blocks functionality when version 3.10 of Liquidnet’s platform is released in late April.
One feature Liquidnet did not change is its pricing. Buyside firms will be charged 2 cents per share, while the sellside will transact H2O Blocks for free. This pricing scheme currently applies to buyside executions against Liquidnet’s SLPs. And Liquidnet’s argument remains the same: those on the buyside are getting big executions that minimize their market impact, while sellsiders, who possess the bulk of the industry’s volume, have an array of immediate low-cost or free execution opportunities.
Keeping buyside customers at 2 cents per share when the other side is executing the same blocks for free may be a bold gambit. Institutions are also increasingly used to paying much less for dark pool executions. But for some, the price may not be an issue. “The commission rate doesn’t concern me since high-touch blocks are often more expensive than 2 cents per share,” said ING’s Buziak.
