KGB: Liquidnet's Seth Merrin

The chief executive of institutional equities marketplace Liquidnet explains why regulators are unable to keep up with a fast-changing exchange market structure, and the creation of a wholesale exchange market is necessary to protect investors.

Liquidnet chief executive Seth Merrin tells Business Spectator's Alan Kohler, Robert Gottliebsen and Stephen Bartholomeusz:

Market regulators are overwhelmed with the job of putting out fires, and unable to keep ahead of fast changing market structures.

The creation of separate wholesale and retail exchange markets is necessary to eliminate the damaging side of high frequency trading and protect smaller investors.

Regulators must do whatever it takes to build confidence in equity markets, and 'cutting the pipes' on high frequency traders would only be a Bandaid solution.

Stock exchanges should play a role in the entire capital formation process, from start up and expansion to public listing.

Stock exchanges should be able to look beyond national borders for investors and capital transfers, and Australia needs to improve the free flow of capital through its exchange market if it is to become the capital centre of the Asia Pacific.

Alan Kohler: Well Seth Merrin, Liquidnet has been going for a while now and it’s a global wholesale trading platform – a sort of massive dark pool, I guess. But to what extent do you think it’s becoming a sort of safe haven from high frequency trading?

Seth Merrin: Well we are, in a sense that we are a venue for investors – just as the stock exchanges used to be a venue for the retail investor and the institutional investor, which used to make up their entire volume. Today at least in the United States when high frequency trading is making up a majority of the volume, institutions are looking around. And it’s a zero sum game. A lot of this high frequency trading is coming at the expense of the institutional investors. So, in the sense that they are looking for some place where they can trade among themselves anonymously, without fear of somebody coming in and being predatory on their order flow, we are a safe haven, absolutely.

AK: So that means you’d be in favour of high frequency trading then, would you?

SM: God forbid, no. I’m in favour of good market structure. I’m in favour of fairness. I’m in favour of making sure that the investors who invest their life savings and pension funds and mutual funds get the most out of their returns. And I’m not in favour of a sort of typical Wall Street 'very few make a lot of money at the expense of very many' attitude.

AK: So do you think that high frequency trading is unfair?

SM: Not all high frequency trading is either good or bad, but the bad part of high frequency trading is when they trade at the expense of the institution. They see an institution create a supply and demand imbalance in the market. The institutional orders are so large that they move the market. High frequency traders train their computers on that kind of a signal trying to, you know, source that out and then they go and they barrage that stock with a tonne of buy orders and they start trading among themselves. And ultimately that results in moving the stock price against the institution, which is a tax on all of our returns, for everyone who invests in mutual funds and pension funds. I am against that.

Robert Gottliebsen: Do you think that our global regulators, and particularly the US regulator, are in the pocket of the big institutions who run these high frequency trading and they basically do what they’re told?

SM: I don’t. I don’t believe in this.

RG: Well, they’re sitting back there and doing nothing. There’s got to be some reason why they don’t do it, surely.

SM: Yes. And I think that they’re overwhelmed. One of the problems with the changing market structure – and it changing so quickly, quite frankly, with different constituents coming into the market place – is that the security regulators around the world are simply not equipped to keep a handle on being out in front of them. And unfortunately what they spend a lot of their time doing is putting out the fires, the fires du jour. And you’re never going to get ahead of the game if you are, you know, continually running from fire to fire to fire. It’s essentially putting fingers in dykes and then watching, you know, all these other leaks start.

RG: Looks like corruption to me. That’s what corruption is.

SM: Well, I don’t know if it’s corruption. It is not the right way of going about it. If you think about the growth in this market, especially with superannuation funds, with the growth of mutual funds, you know, the institutional investment sector has grown forty times over the last thirty years. That's thirty years, since 1982. Not a long time ago really.

You know, this industry was a mom and pop kind of industry, right, in the United States. The institutional sector was $200 billion dollars total. It’s nothing and it’s grown very large in a very short period of time and unfortunately the regulators – and not only the regulators but the market structure – hasn't kept up with that pace of growth. And I think at this point, sort of like the tax code in the United States, one has to sit back and rethink and say let’s fix the underlying problem – the underlying infrastructure – as opposed to, you know, painting this bridge that’s about to collapse on the underside.

Stephen Bartholomeusz: Seth, we’ve had in the United States a multiplicity of exchanges emerge, plus of course a whole bunch of electronic trading platforms like yours and this emergence of high frequency trading. In terms of the long-term future of the lit exchanges, the traditional exchanges, if we don’t do something to arrest the fragmentation and the growth of high frequency trading, what happens to them?

SM: Well, I’m very afraid of that, quite frankly, and I think there are multiple issues there. One is that yes there are all these off exchange trading venues, especially what they call dark pools now. Not all dark pools are created equal and most of the dark pools are operated as internalisation engines of the large broker dealers. And you know, I think that for regulators all over the world now the number one and two issues that they’re dealing with are dark pools and high frequency trading.

So those are two separate issues, but you know the delineation seems to be coming down too. And I think Mary Shapiro at the SEC said it very well and that is, you know, if you’re providing value above and beyond what’s found on the exchanges – meaning the size of the execution, the price and and something that’s, you know, you can’t get on the exchange then that’s a good innovation for market structure and we should continue it. However, if you’re not providing value above and beyond what’s found on the exchange, maybe twenty or thirty of these private exchanges are really not good for the market and I agree with that. So, you can see that a lot of these dark pools are going to be forced to move their volume back until it exchanges which, quite frankly, I think is a good thing for the market structure, for price formation.

The high frequency trading debate is really one of confidence in the markets. You know, never before – well, not in a long time anyway – have the retail folks and the press been talking about the market as a casino, as being rigged against the individual. And how can you argue with that when you see such strange things happen. Where a price of a stock can go from $40 to a penny. And, you know, I put a stop loss order in there to sell it. I pulled it. I’ve held this stock, let’s say, for thirty years and all of a sudden within a minute I sell it and look at the price. You know, we don’t understand that. And how do you prevent things like that?

AK: And so, what is the answer? What do you think should be done about high frequency trading?

SM: Well, I think that you have to fix the reasons that enable high frequency trading and it all comes from the underbelly of the market structure. And in our view you have to take the institutional investor sector as very, very serious. That’s whom you should cater to. You should cater to investors, whether they’re retail investors or they’re institutional investors.

AK: But what does that mean? I mean what exactly are you talking about?

SM: I mean that we have such a large amount of institutionally managed assets. One should create a wholesale market. Like every other industry has created, right? Since the general store that will buy and sell little sorts of goods. Now ever since congresses has increased, you know, entrepreneurs have created the wholesale markets that would feed the retail markets.

Unfortunately, you know, because the exchanges are so highly regulated, many of them are still monopolies. It’s still one store that everyone has to go and buy and sell their goods from. Unfortunately if you have to buy six thousand sweaters, you can’t go to the retail store to fill that order. That is an institutional order and that’s what they’re forced to do.

So, create an institutional wholesale market and let the retail go and buy from the wholesaler. Once you do that, you know, if you have $10 million dollars’ worth of a security to buy, you need very different tools than if you’re buying $1000 worth. And if you have $10 million dollars of demand going and trying to buy $6000 worth at a shop that has $6000 worth of supply, that will never work.

AK: But I don’t understand why that would get rid of high frequency traders. They’d still be operating in a high frequency way in the markets that you’re talking about, probably both wholesale and retail.

SM: Well, the bad high frequency trading that I’m talking about really is where the high frequency folks listen for that supply demand imbalance. So, if you have $10 million dollars’ worth of demand and there’s only $6000 worth of supply that creates the imbalance. If you reverse that and you make the $10 million the supply that can certainly supply the $6000 worth of demand, no problem. There’s no signalling that’s going on there, right. There’s no supply demand imbalance.

You’ve just fixed the market structure by doing what every other industry, from retail to grocery stores, has already put into place. That is the kind of infrastructure that we need in here and if you make institutional investing more efficient, that’s good for the market structure. Those are the folks that invest in, you know, the growth companies, the expansion companies, the public companies. And ultimately more efficient investing brings more capital into the country. It’s good for the economy.

RG: We had a long interview with the chief of the ASX here a few weeks ago (KGB: ASX's Elmer Funke Kupper, August 27). And he doesn’t believe our regulator is corrupt, but he believes the regulator is going to change the high frequency trading rules to make them fair, and he agrees they’re unfair at present and after a lot of pressure, he agreed that if they regulator fails in that task, we’ve just got to cut the pipes.

And there was only one thing and I suspect that’s the only answer to this: you cut the pipes. Now if our regulator can do it that way, we should give him a chance. That’s fair. But if he fails, then you cut the pipes and you cut them all around the world and we have a nice, clean world.

SB: You’re talking about the millisecond advantages.

RG: Those direct pipes into the market get cut and stopped. You have to end the contract of course and you don’t just cut them, but these guys have got contracts and those contracts are not renewed.

SM: I do believe that the regulator should be a principle based regulator. They should have a vision that should guide everything that they do and ultimately the vision that should guide them today is anything that they have to do to build confidence in the markets and especially, right now, the equity markets. So, you know, I think that cutting the pipes is again a Bandaid to a big problem. It can solve this problem and I won’t disagree with that, but I think that ultimately what’s going to happen is they’re going to resurface somewhere over here and you’re going to have some other pipes that you’re going to have to cut unless you can fix the underlying structure of the problem itself.

AK: But what Hong Kong does is they have the stamp duty on the buy and the sell side and no high frequency trading because it doesn’t make sense economically.

SM: Correct.

AK: So, is that the answer?

SM: Again its a patch on a more serious, underlying problem. It solves the problem temporarily and I’ll agree with that in the absence of a better solution, of a more holistic solution. So, there’s that. There’s a minimum execution size which will slow down or stop high frequency trading. There are lots of things that one can do and I think that they’re all incrementally better than doing nothing. But again I think that we have to rethink the structure of the markets and if people are afraid of rethinking that, then ultimately you’re not going to fix the problem.

RG: Now, let me just understand better what you want to do with the markets. You’re talking about a wholesale market. Let’s take BHP Billiton for want of a stock, and you’re suggesting that someone should take a position in BHP and then supply the orders as they come through.

SM: People that are already taking a position in BHP are the institutional investors around the world.

RG: Yes.

SM: Now, when they want to get out of a stock, what they should do is they should make that supply. They should open it up to all of the other investors around the world that would like to buy and sell that stock and that should be the market.

Now, that’s not a whole solution. In order to have an efficient market you need both a market where trades can happen without an intermediary when possible, but when an intermediary is necessary you need market makers to facilitate that too, but that can be done within the confines of a wholesale market. All I’m saying is, and this is why I use the analogy, if you are a department store you’re not going to go to the corner store to buy 6000 shirts or sweaters. It’s not set up to do that. And this market should simply operate the same way. You have, you know, a massive amount of wholesale money that has huge positions that want to buy and sell and can be a much larger depth of market than what we have today in all the markets.

AK: But that wholesale market that you talk about has to be global, right.

SM: It should be global.

AK: It needs to be global but at the moment the way the markets are structured everything is around national borders. Part of the reason you’ve been successful is because you offer a global, wholesale market, but it’s dark. That’s the problem. Maybe the answer is that you guys will just take over.

SM: No, I don’t believe so. I think that we should work in conjunction with the exchanges around the world. Forget about dark and light. You have price discovery which is the exchanges, which is really critical. We need it. We want it. It should be there. And then you have quantity discovery , which the exchanges do not provide. But in order to have an efficient market you have to have price discovery, but you also have to have quantity discovery or else you’re really not doing a service to all the institutional managers.

Think about all those folks that have to put money into the superannuation every single day or every single year. You want those markets to be as efficient as possible so that they get the best returns that they possibly can. And you know what compounding does over time; it’s massive. So, we have to address the problem again at its core I think, so that ultimately people can retire with the amount of money that they need to be able to live.

SB: Are you saying we should bring the dark pools into the sunlight?

SM: No. I think that, you know, you have to treat wholesalers the way that they need to be treated. Nobody actually would put $10 million dollars’ worth of demand in view of everybody when there’s only $6000 dollars of supply. That’s not realistic. You can’t go into a wholesaler and find out the cost of goods. You can go into a retailer and all the goods are clearly labelled. It’s no different from every other market. Let’s do it that way, right? Retail should have transparency and we should be able to see exactly what everything costs. In the wholesale market you just cannot. The more you give up the actual supply and demand, or the intent of what these people want to do, ultimately the more it’s going to cost us, the shareholders, the investors and those funds

AK: But are you saying that the price discoveries would continue to be required from the retail market? It would have to be supplied…

SM: And it always has been. And it always will be.

AK: But no, even in the structure you’re talking about with the wholesale and retail, the retail market would supply the price discovery, not the wholesale market.

SM: Yes. That’s correct.

AK: So, are you talking about a global stock exchange?

SM: I don’t know that we need to call it a global stock exchange. Every stock exchange is highly regulated by a local market. I do believe in, you know, in using technology to create a more seamless wealth capital around the world. Now, stock exchanges have never really looked beyond their borders for investors, or to be able to actually transfer an investment from their internal borders to the rest of the world, but you know they should be in that position. They should be in that business.

And for every market out there, there’s more money outside of your borders than there are inside of the borders. The stock exchange’s role should really be about the full capital formation process. They should be the efficient mechanism to bring capital in. You know, you don’t have a really good start-up capital formation process here, but that should be, wholesale, I think, the job of an exchange – to bring capital at every part of the capital formation: the business formation process; startups, expansion, you know, and ultimately when it’s public and beyond.

SB: The liquidity pools, as you describe them, are actually national – but naturally national. So the US market is the biggest market for US stocks and so on and so forth. But to get the kind of global liquidity pools that facilitate the sort of things you were talking about, we do need some kind of global exchange or a much bigger liquidity net, don’t we?

SM: Well, what we’re doing is, we have connected for the first time, using technology, over seven hundred of the largest asset managers on earth and combined they manage over $12 trillion dollars’ worth of equity assets. So, in essence you’ve got a centralised pool of assets that could actually float to where it’s most efficient and where the best returns are.

What we have to do is we have to build better infrastructure in the different places for the first time ever. You know, you have a desire to move a massive amount of assets from where they’re held today, which is the west, into faster growing economies and better opportunities. The problem is we’re going from a five-lane highway and a massive amount of truckloads of money that ultimately would like to go to where there are only dirt roads, right, in terms of their infrastructure. So, you know, part of our job and responsibility is to provide more and better plumbing, better infrastructure, to be able to allow them to move money from one place to another without incurring these massive costs and charges on the way.

If we work with exchanges around the world, well we have this massive amount of capital that would love to be able to move seamlessly, right, which would be great for everybody’s returns – and working with the exchanges, which is where the majority of the liquidity is in each country. If we combine our liquidity pools, we bring a massive amount of liquidity to wherever we are from the outside of that country. The exchange brings the massive amounts of liquidity from within the country. We share that liquidity in a way that works for everybody, where retail can actually buy from the wholesaler and you create a much more efficient market structure. And that, quite frankly, can be a competitive advantage for any country that wants to actually increase or make their markets more efficient from a regulatory perspective, from an infrastructure perspective, from an exchange perspective. And, you know, capital is going to flow to where it flows most efficiently. And if Australia wants to be, you know, the capital centre of the Asia Pacific, well you have to enable the free flow of capital into this market. It’s not only regulation, obviously, but that has a lot to do with that right now.

SB: So, practically what could we do to enable that?

SM: Well, again I think that you fix the underlying problem and you create a wholesale market. You have it interact well with the retail market and you combine those two liquidity pools, as we’ve done with the Swiss stock exchange and other exchanges that we’re talking to around the world. You have to again rethink the whole concept of what the market needs for efficiency, whatever we can do to enable the capital to move from one place to another without incurring these massive charges over that, having to worry about the predators like high frequency trading, putting a tax on our returns.

And I’m saying just, you know, implement the same structure that has worked for every other industry, period. We’ll be the wholesale market. We’re happy to do that and we bring the global investors with us. But we have to work with the retail market and we have to work with the exchanges, because I think that exchanges are absolutely critical for capital formation within each country.

AK: It’s been great talking to you, Seth. Thanks very much for joining us.

SM: My pleasure. Thank you.

SB: Thank you, Seth.

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