It is a marriage of great expectations. In the great game of Nasdaq trading, Merrill Lynch & Co., the nation's largest brokerage firm, and Herzog Heine Geduld, an unpretentious and independent wholesaler, may seem like an odd couple.
Merrill, a full-service firm for retail investors and institutions, did not actively court the smaller accounts and broker dealers that were Herzog's bread and butter.
Merrill and Herzog both had a different approach to trading. "Herzog traders were trained not to lose money. A Herzog trader might do size but he'd be careful about risking capital," said one respected veteran trader.
"Merrill would buy a couple of hundred thousand shares and lose some money, if necessary, to satisfy a client," added this trader. "Merrill, a much larger firm, could afford to."
Merrill internalizes and does not pay for order flow. Herzog, on the other hand, a "dealer's dealer," paid for order flow.
But Merill and Herzog – opposites in so many ways – were alike in others. Both are reputable titans in the Nasdaq dealing world. The share volume of the combined firm placed it as the number one Nasdaq market maker in the world, according to figures supplied by Nasdaq for the 12-months ending March 31. (That prize was captured for the month of April by Knight Securities, though it was neck and neck with Merrill and Herzog, which combined was ranked No. 2, executing some two and a half billion Nasdaq shares.)
Complimentary Lines
Merrill and Herzog also had complementary lines of business which did not overlap, according to analysts. The chemistry worked. On June 6, 2000, Merrill and Herzog tied the knot: Merrill Lynch acquired Herzog Heine Geduld for $920 million in stock – at the pinnacle of the online retail stock trading boom.
The attraction, clearly, was motivated in part by Merrill's desire to cash in on the boom and instantly add more volume. At the time, noted Putnam Lovell Securities, the acquisition put the largest proportion of Nasdaq's retail order flow into Merrill's hands.
But Merrill's designs were dealt a serious blow when industry retail stock trading crashed. It was down 59 percent compared to the first quarter of 2000. Still, Merrill in buying Herzog, had more than the online trading bonanza in sight.
Soon after the deal was announced, a Merrill spokesman said it would enable Merrill to internalize more of its order flow. There were other strategic reasons. Merrill, which dropped the number of stocks it made markets in soon after the order handling rules – to some 550 from 800 – reaffirmed its confidence in the OTC market making. And it was building a strong foundation for its other lines. These include the potentially lucrative equity underwriting and merger advisory businesses.
Earlier this year, Merrill and Herzog's trading operations were combined, a process likely accelerated by the unexpected and harrowing events on Sept. 11. The attacks temporarily deprived Merrill of 150,000 feet of trading floors in the World Financial Center. It forced Merrill's Nasdaq and listed traders – who work together in sector teams – to relocate to Herzog's trading desk across the Hudson. It shoehorned hundreds of pros – a mass of hollerin' and screamin' traders – into 60,000 square feet. But it also taught both sides an instant, valuable lesson: The integration could proceed sooner.
In a wide-ranging interview with Traders Magazine, four top trading executives who will help drive the recently integrated Merrill and Herzog Nasdaq units, dubbed Merrill Lynch Nasdaq Trading, spoke about the company's goals, strategy and outlook for the new outfit.
Time and Money
The four pros are pleased Merrill has accomplished something that might have taken even more time and money. "We were in the early stages of building a trading floor in Jersey City and this buy opportunity came along," said Tom Wright, a managing director and head of U.S. equity trading and sales trading.
"It was a classic buy-versus-build strategy," added Wright, who is responsible for managing all areas of Merrill's listed and Nasdaq business as well as the U.S. portfolio trading business.
"We were a strong wholesaler and Merrill was a strong institutional house," added E.E. "Buzzy" Geduld, chairman of the combined new trading unit. "When you combine them, you've put the best of both worlds together."
Most of the integration is completed. There only remains "some operational issues to be worked out in the coming months," Wright said. Today, Herzog's market maker identifier – HRZG – has been replaced by MLNJ, while its order flow has been effectively melded with Merrill's, which uses the identifier, MLCO.
Prior to the acquisition, Merrill had recruited a trading pro, Michael Bird, previously a managing director of equity trading at Dain Rauscher Wessels, as a senior market maker. Bird, who still works as a trader at Merrill, was assigned to help manage the planned Jersey City wing. But that plan soon unraveled.
Merrill's build strategy was based on a simple economic principal. Ken Worthington, a brokerage industry analyst at CIBC World Markets, said it would have been too expensive for Merrill to recruit heavyweight market makers one by one. "Merrill could not cherry pick individual traders at prices that made economic sense," he said. "They are paid a lot. It made more sense to acquire another market maker firm."
Cost-Conscious
Merrill, indeed, which is cost-conscious in these lean times, eliminated dozens of trading jobs in the wake of the deal. Some found work at rivals, such as Jefferies and Knight Securities; some retired from the business.
Since the end of the first quarter of this year, Merrill's overall workforce has declined from some 70,000 to about 56,000, as profitability slipped. In the first quarter of 2002, Merrill, which had revenues of $647 million, saw profitability drop 26 percent (compared to the first quarter of 2001). Still, profit margins are rising. And Merrill is determined to produce bigger margins by the end of the year.
Merrill could eye reductions on the trading side, according to CIBC's Worthington. It will closely watch compensation and overhead costs. Worthington noted that Merrill brought Herzog compensation's structure in line with Merrill's, basing a trader's pay package on a salary plus a bonus plan instead of pure commissions.
Another area under review is Herzog's policy of payment for order flow, which though less generous because of penny pricing, is still a huge cost. "Payment for order flow is under review and we're in conversations right now," Geduld said.
Added Wright, "It's an age-old issue and there hasn't been an affirmative determination about it. The most important thing is our best execution obligations."
Gloom
Of more immediate interest is the overall profitability for Nasdaq market makers. The outlook is gloomy. Some analysts predict continuing job losses on desks, more consolidation. ECNs, in which Merrill has some ownership stakes, have directly raided order flow from dealers. Geduld dismisses the pessimists, saying "the geniuses of Wall Street said market making was dead before."
"I've been doing this for more than 30 years and have seen several cycles," he said. Each time it supposedly died, it came back bigger and better. You can't look at the business over a 12 or 18-month period. So one of the things we're thinking of in a time like this, is how to expand. We think there are opportunities."
Added Dante Ferrarie, a managing director who oversees U.S. Nasdaq sales trading: "I don't see the role of the market maker and their expertise in finding buyers and sellers, disappearing."
Brad Hintz, the analyst concurs. "Merrill did not buy Herzog because they were making a bet that Internet stocks were coming back. No, they did it because they saw it as an opportunity to put an equity business into an already strong franchise and build scale. They could have picked a better time, but fundamentally there's nothing wrong with the strategy."
Does Merrill regret the timing? Merrill's window of opportunity was limited because other firms were circling Herzog. Geduld acknowledged that other offers were made. But he added, "From Merrill Lynch's point of view, the deal instantly gave the firm the ability to trade 10,000 or 12,000 [additional] stocks overnight." Those thousands of stocks, on top of Merrill's roughly 800 Nasdaq stock market making menu, create a powerful new dealer engine on Wall Street. That's a machine operated by a fully-integrated brokerage house, a machine supported by Merrill's huge capital base. It's a machine that will allow Merrill's traders to glean insights from institutional and retail flows.
On Merrill's portfolio trading side, Merrill's addition of Herzog's stocks, will fit well. "The more names you make, the less business you have to send to a wholesaler you don't own. It's all about keeping order flow in-house," said one buyside trading pro.
Portfolio trading, unlike the oftentimes low-margin block trading business, is more profitable. It traces its roots to the volatility of the recent bull market. That's when trading single names could flatten a portfolio. In response, portfolio managers started raising cash across a portfolio of names in equal percentages. The growth of order management systems provided some of the necessary technological backbone.
The combination of Merrill and Herzog on this front is not lost on Merrill's executives. "The synergies between Merrill and Herzog on the client base side were fairly overwhelming," Ferrarie said. "Herzog had a client base that we hadn't penetrated as much as they had, and we had a client base that they hadn't penetrated as well. It was a pretty incredible list combined."
Split Trading
Merrill will maximize the opportunity, segregating trading into two groups: large-caps at Merrill's trading room on the fifth floor at 4 World Financial Center in New York; small to mid-cap stocks in Herzog's digs on Washington Blvd. in Jersey City.
On the New York side, Merrill research and sales people will continue to service its large institutional customers and individual investors. Merrill's recently formed U.S. small and mid-cap specialist sales group – as well as its research – will be available to both its traditional customers and the group that was the core of Herzog's business. These smaller broker dealers and smaller institutional accounts, sent much of their order flow to Herzog electronically. Herzog did not provide research.
"We heard from institutional clients that they were frustrated by the liquidity available in the mid- to small-cap sector," said Leo Ressa, managing director, head of Nasdaq trading. "We think the combination provides them a solution."
"On the flip side of the coin," Ferrarie added, "clients who use our services from the New York location are excited that they'll have access to expanded services in the small-cap names."
The introduction by the largest dealers of explicit commissions, or agency style trading on Nasdaq, could play well for Merrill in the institutional market. "In future it will be much easier to go to firms like Merrill and get a risk trade done – or pay a commission if necessary – on a small- to mid-cap name," said Tom Bardong, head of trading at Alliance Capital Management. "In the past, firms were dropping these names. Now it is easier for firms to manage the process when there is definitive commission there to support the names."
Merrill's ability to put up capital will also be extremely helpful. "Capital is more important that it has ever been," Bardong said, "particularly with the whole syndicate calendar wiped out. Sellside firms have never been as aggressive as they are today in their willingness to put up capital."
Merrill has another thing going for it: Huge captive order flow. That stretches as far as the eye can see: from the order flow handled for customers of Merrill's clearing affiliate, Broadcort Capital Corp. (as well as Herzog's old clearing accounts), soft-dollar transactions on behalf of another Merrill affiliate, Citation, and executions for a laundry list of major accounts.
"The more order flow Merrill can control," said one buyside trader, "the more they can cross. The more they can control, the better feel for the market their traders have, which makes committing capital less risky."
The marriage of Merrill Lynch and Herzog could be a prodigious success.
