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Shining a light on dark pools: interview with Seth Merrin

It may come as a surprise to many retail investors, but not all trades in listed securities take place on the so-called ‘lit’ public exchanges, such as the ASX. Increasingly, they are moving to the ‘unlit’ markets, or dark pools, and if you hold managed funds with a large portfolio manager, this could be good or bad, depending on who you listen to. Supporters argue that execution is improved and costs are reduced, to everyone’s benefit and the efficiency of the market. Opponents point to the lack of transparency.

Dark pools are as mysterious to many as the name evokes, and the Australian Securities and Investments Commission (ASIC) is watching. On 12 August 2013, ASIC released new market integrity rules on dark liquidity and high frequency trading. ASIC said, “These final rules aim to improve the transparency and integrity of crossing systems and strengthen the requirements for market participants to deter market manipulation.”

A dark pool is an off-market exchange that allows traders to buy and sell large orders without revealing their identity. The primary purpose is to minimise the market impact of an order by not revealing quotes to the market. In theory, they allow institutions to minimise information leakage and execute more efficiently. Most dark pool liquidity is block trades away from centralised exchanges such as the ASX.

Seth Merrin is the founder and CEO of Liquidnet, a global institutional trading network founded in 2001 that connects 750 of the world’s leading asset managers, including many in Australia.

Liquidnet opened in Australia in 2008, and some statistics are:

  • average daily order liquidity in ASX stocks is about $2 billion (actual daily average ASX turnover is about $5 billion)
  • average execution size is $1.8 million (337 times larger than ASX of $5,344)
  • 98% of trades at or inside the public bid/offer spread, with 84% at mid market
  • Liquidnet represents an average of 47% of the Average Daily Volume when active in a stock, and is active in almost 150 stocks on the ASX.

Here is my interview with Seth Merrin:

G. How is Liquidnet going in Australia?

S. Australia has been the most successful launch of any country in our history (Liquidnet operates in 42 markets over five continents). It’s such a close-knit community with some of the brightest people we find anywhere in the world. People are passionate about what they are doing. Superannuation has made the industry more professional and efficient. There is focus on it as a business and industry. Australians are more engaged with their super as investors, whereas in the US, people ‘play the market’. I realise this is a generalisation, but it’s what I perceive.

G. Large asset managers match orders between their funds internally before executing the balance on an exchange. Is that like Liquidnet?

S. It’s exactly what they should be doing, to avoid transaction costs. The problem that we’re solving is that institutional assets are so large that they move the market when they transact. The commission or brokerage they pay is only a small part of the cost. If they can cross internally, fine, but it’s usually a small part. Think about the benefits of transacting internally and magnify that massively across the world. Liquidnet brings to the table members all over the world trading in different markets for different reasons. Only through technology can you know there is someone sitting in California wanting to buy an Australian stock and we match that with someone sitting in France or wherever. Bringing lots of different perspectives to the table is what makes a market. A massive amount of assets around the world is what makes for liquidity.

G. The initial stages must have been have been tough, it’s all about liquidity.

S. Yes, excruciating. Our initial asset managers said ‘don’t call us, we’ll call you’. But they were educated that they had a problem. Blocks were previously traded through a human intermediary, but when you give someone a block like that, they can only make so many phone calls. They won’t call folks in Europe of America. And there was a low probability they would find the other side. But there was 100% chance they would provide information to the market which compromised the deal. Firms like Goldman Sachs and Bear Stearns were built on block trading.

We simply introduced technology. What ebay did to flea markets, we did to block trading, to the institutional world. You need very different tools if you’re trading $10 million of stock than $5,000. Every other industry has a wholesale and retail market, that’s what we created across the world.

Also, most asset managers are comfortable transacting in their home market. But Australian superannuation funds are growing at 18% a year, just on the equity component, they have to find $100 billion a year of new investment. There are only 2,000 public companies in Australia, that is a major problem for them.

G. And highly concentrated in certain industries.

S. Right. So, it either creates a bubble, or difficulty outperforming, and there are 45,000 public companies around the world. Australian asset managers have to look outside Australia. But global investing is difficult, learning the rules and regulations of that country, which broker do I use, do I trust them, how do I do it. Then think about a technology solution that allows them to point and click and invest almost anywhere, and we aggregate the liquidity for them in 42 markets. They can look outside their back yard.

It opens opportunities for improving asset allocation. In traditional asset allocation, we have a certain amount in cash, bonds, equities. The real opportunity is looking around the world at different levels of risk and return, which is what asset allocation is about. Look at Europe, Asia, Africa. It gets you away from benchmark hugging, generating pure alpha as active managers have to earn their fees. That is where asset allocation must move. We’ve seen a lot of money move to Europe, not because it’s a great growth story, but because their share prices have been beaten up. Whereas Asia is a growth story worth some percentage of your assets.

G. How do the public exchanges respond to your business? Is the ASX a friend or competitor?

S. When we first started coming, they saw us as a competitive threat. But over time, they all tried to create their own version of what we’ve done, and they’ve all failed. But they understand, they are the pricing mechanism, that is sacrosanct, but they’ve never been good at dealing with large quantity price discovery. They’ve never really catered to large institutions, so they understand we are complementary. They are price discovery, we are quantity discovery, together we serve both markets more efficiently.

Their real competitors are their major customers, where major banks and brokers have set up their own internal matching engines everywhere around the world, and the exchange has become the execution point of last resort.

G. Are there any issues about loss of liquidity on the main exchanges?

S. Not due to Liquidnet. We’ve never been a competitor. There are two major issues on the minds of regulators all over the world – high frequency trading and dark pools. So why were dark pools invented in the first place? They were invented for institutions who need the anonymity, they need the size, and a better price. Over time, internal engines of investment banks have created maybe 50 dark pools in the US, but the execution size is lower than on the major exchanges, and that’s wrong.

So regulators are drawing a line in the sand and saying if you’re going to trade in the dark, you have to do something that complements the ‘lit’ exchange. That is, size, price, or something. Canada and Australia were the first to introduce regulations to control the spread of dark pools. ASIC said you must price improve, and most volume has migrated back to the lit exchange.

G. Liquidnet operates a dark pool, but what do you think of the description?

S. We don’t like associating Liquidnet with the term ‘dark pool’. We’re a quote-crossing network. We don’t provide quotes. The difference in what we do versus dark pools is that we are a block execution venue, we don’t do small trades. It’s a myth that dark pools are executing at prices away from the exchange. Note that 99% of Liquidnet’s transactions globally are within the current bid/offer and 85% are done at mid. The trades are reported instantly into the ASX. There’s been this misconception about whether the trades get reported, and they certainly do. The reality is that the large block trades were never done on the public exchange anyway, they were done in the broker offices using broker interaction. We introduced execution efficiency.

G. I perceive as an industry outsider that some people confuse dark pools with high frequency trading (HFT). Is this an issue?

S. I don’t see that confusion but I’m too close to the industry to judge. Certainly, HFTs trade a lot in the dark, and regulators are concerned about manipulation, such as executing in the dark and manipulating prices on the public exchanges. But the average investor maybe thinks this whole thing is bad for them, that it further rigs the system against them.

HFT is a big structural issue. Many ‘for profit’ exchanges are encouraging as much HFT as possible because they earn commissions, but they have to understand that exchanges were created as the capital formation centres in their country. It’s a place where companies can raise money for expansion and growth and where investors can exchange their shares efficiently. HFTs don’t invest in IPOs or secondary placements, they don’t increase efficiency of institutional trading.

Let me explain why this is an issue. We still have a confidence problem in the equity market, but over the long term, that’s where the money will come. We saw a trillion dollars leave equities and go into fixed income during the financial crisis, but it will come back into equities over time. The bulk of that money is now up for grabs. It will flow into the best, most efficient opportunities. If there are regulatory hurdles, if trading is easier, if regulations are more standard (I think ASIC is doing a fantastic job, this is an easy market to transact in), whoever gets their act together will see the capital flows. For example, India looks like such a fantastic country to invest in, but there are such constraints on transacting for foreign capital, that the capital will not go there. If, for example, Indonesia gets it rights, they could generate massive capital flows. Every government is trying to attract foreign capital. Here’s a trillion dollars, go get it.

G. You’re a high profile critic of high frequency trading. Are you winning?

S. The ASX has shone a spotlight on it before it gets out of control. If it’s 30% of turnover, as it is here, then it’s fine. Anytime you cross over the 50%, as in the US, then the market changes from retail and institutional investors that care about the correlation between price and the underlying fundamentals. If you cross the threshold, you go from an investors market to a speculators market. In the US, we have done nothing about it. We’re good at talking, not solving.

So I give a lot of kudos to this market. ASIC brings the industry in with consultative papers, they’re thinking about the problems. Contrast that with the SEC (US Securities and Exchange Commission) that holds panels which are very public, it’s a cartoon they put on, it’s meaningless. In front of the cameras, they read politically correct statements and nothing happens. Australia has done a lot of things right from a regulatory and market structure perspective.

G. That’s interesting, because locally, we do a lot of criticising ASIC.

S. Good, keep it up, then come to the United States where the grass is certainly not greener.

G. Why only equities and not bonds, repos, money market for Liquidnet?

S. It’s all about focus. Our strategy is to put down a global footprint, and we’ve done that by focussing attention, time and money. We have to create a critical mass of liquidity in each country. It’s taken 12 years, 750 of the largest asset managers around the world as clients, we want to solve more of their problems. We only enter a business when we can improve efficiency. We are looking at other asset classes, but there are unlimited debt instruments around the world, and we can’t apply the same business model.

G. I was thinking more about the domestic money market which executes the same way as it did 20 years ago, by phone calls from banks to investors. It’s a generic product, a major bank certificate of deposit.

S. It does not take much technology to create a disruptive event. Everything we do is a global opportunity to make markets more efficient, but one thing at a time.

G. What’s next for Liquidnet?

S. Our mission is to make markets more efficient. If you think about public companies, it’s a nightmare every time they want to buy and sell stock, for example, to do a buyback. They have to call an investment bank and put a human in the middle. Those companies want our members around the world at their table. They have fiduciary obligations to shareholders to get the best price, and it’s great for our members.

The other area is private companies. Our members have not invested in private companies, but if you take a look at the trend towards large IPOs. Look at Twitter, floating with $15 billion of value. Our members have missed out on $15 billion of alpha. Or Facebook with $100 billion of alpha. It’s pre-IPO where the value is. Our members are reading about these companies staying private for longer, going public at high valuations, so we want to institutionalise the ability to invest pre IPO. Not start ups. Real companies with real revenues with real prospects. The start ups are for venture capital. We’re bringing a massive source of capital to invest, which dwarfs venture capital. But at the moment, it’s not an institutional asset class.


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