The Gateway to Algorithmic and Automated Trading

Going with the flow

Published in Automated Trader Magazine Issue 28 Q1 2013

Liquidnet does not fit the typical dark pool profile. For one thing, the venue is only open to institutional buy side firms. For another, the users collectively control more than $13 trillion in assets. Automated Trader caught up with Chief Operating Officer John Kelly to hear what the venue and its members have been up to, and where it's going.

John Kelly

John Kelly

AT: Could you tell us about Liquidnet's origins?

John: About 12 years ago, Liquidnet was founded on a premise that institutional investors, traditional buy-and-hold investors, have very particular needs that - back then and still today - are not well met by the market at large. Seth Merrin, our founder and CEO, had the notion that if we created a community of like-minded and similar-profile institutional investors they would have the opportunity to interact directly with one another and be able to trade in the very large-scale blocks, and to do so in a way that enables portfolio managers and traders to capture the maximum returns in their portfolios. 12 years on, there are perhaps as many as 50 dark pools around the world, and yet no one has a model likes ours, which is buy side only. And what I find as I've gone out and met our members is that the core value proposition of Liquidnet is reinforced over and over again.

AT: By having a members-only policy you are, by definition, to some extent cutting off some sources of liquidity. So it's always been the business model to keep it that way?

John: When our members log in in the morning they allow us to see all of their intentions for the day from their blotter. And based on those indications, we find other members - we have over 750 institutions around the world who manage approximately $13 trillion of equity assets under management - to match up those indications. It provides the opportunity for two traders to contact one another directly and anonymously through their workstation and negotiate a transaction, or not. If, for whatever reason, they chose not to trade in the Liquidnet system, obviously they can go outside and trade anywhere in the market that they like. But the power of the Liquidnet model is that, given this global presence that we have with this large community of investors, it is in fact the largest and deepest pool of natural liquidity to be found anywhere.

AT: In that sense, is a lot of this activity automated?

John: First, our members start out their day by sharing anonymously in our system their intentions for buying or selling securities. There is this exceptional level of trust that's required for an institution to tell you what he intends to do before creating an order. Second, by sharing those indications, it creates the opportunity for two individual traders to negotiate directly. It's two people who decide to interact while maintaining anonymity and they are interacting with the confidence that it is another buy side firm just like them.

Going with the flow

The second thing that can happen is if you have, for example, 800,000 shares of stock that you are looking to cross, you may find that you've crossed 780,000 shares of that 800,000 and you have 20,000 shares left to go. Our members can then finish their large order by using one of our quantitative trading strategies, an algorithm, to finish the order that they started through that manual negotiation. Those algorithms are distinct from the rest of the market, first and foremost because they are still available to interact with our members-only pure buy side natural pool. The other thing about our quantitative strategies is that a member can, at their choosing, decide to send that order to the external market, and through our algorithms, they can then access liquidity from the sell side or in some cases directly through members of a stock exchange.

AT: All of that brings up a couple of questions. The share of those left-over trades, what is the ratio of those and the negotiated, manual trade that takes place and what is the trend there? Also, within that sub-set, how much of that stays in the member community and how much of that goes externally to widen the sources of liquidity?

John: 75 percent of all trades are negotiated manually member-to-member and about 25 percent are orders that are executed through one of our algorithms. Some of our algorithms are designed to interact only within our natural pool while others interact simultaneously with our natural pool, the member community, and at the same time, with external liquidity outside our community. And then lastly, there are some algorithms that are designed to interact only with liquidity that we access outside of our pool.

AT: But you see a fair share in all three of those categories?

John: It floats around.

AT: How would you characterise the algos you provide?

John: Our algos are a fairly representative sample of the traditional eight or nine most typical categories of algorithm. So, the general volume-weighted average price category, implementation shortfall, percent participation over the course of the day.

AT: Do pretty much all the members, or most of the members, use those algos?

John: I can tell you it's fairly broadly the case that our members use algos to create orders, clean up residuals and interact with the street.

AT: On a broader level, what are some of the trends within the member community in terms of types of new members coming on board, the kinds of trading opportunities they are interested in?

John: Our members are among the most sophisticated institutional investors anywhere in the world and they are constantly seeking opportunities to deploy capital where returns are most attractive anywhere in the world. So as a result, we have built, over several years, the ability to execute large-scale block transactions in 41 markets around the world. The most recent markets that we have opened up include the Philippines and Turkey.

In addition to being able to execute very large blocks, among all the developed economies and major exchanges, we have far and away the largest, broadest capacity to do buy-side-to-buy-side block trading in emerging markets, whether it be the eastern bloc countries of the continent or Southeast Asia or anywhere in the world. That's clearly one of the biggest trends that we've seen over the last several years.

AT: How do you determine when you want to go after another market? What are the criteria?

John: It's a relatively straightforward exercise. First, you listen to your clients, and our members tell us what they're looking for. Second, we can see the depth of liquidity requirements that these very large, global investors have and we will know if they have an appetite to trade in a place such as Turkey or the Philippines. And lastly, we look at the depth of liquidity in the respective markets, the regulatory framework, and the technology of being able to execute, process, settle and report trades. It starts with being directly responsive to needs that are expressed by our members.

AT: Before you add a new market, two members can still negotiate a trade over your network but just not execute?

John: It starts with two members. There's one who is a buyer of, let's say a Philippine stock, and there's one who's a seller. Bearing in mind again our members are transacting in very large scale. If they took that order and gave it to a broker directly who is a member of the Philippine Stock Exchange, there might be adverse movement in the price. By negotiating directly with one another, again anonymously, in our pool they're able to transact, typically at a mid-point price, and then that order is directed through a local broker and reported on the exchange. So the negotiation and the trade are executed directly through us, but the actual clearance, settlement and reporting is through the local broker on the exchange.

Going with the flow

AT: So the clearing, settlement and reporting is where you have to do technological work.

John: The concept is very straightforward but there are regulatory issues, plumbing issues. We have a very highly developed expertise in understanding, particularly in these emerging markets, how to work with the local regulators, the local exchange, the local broker and a clearing firm, to enable our members to negotiate that transaction directly in the way that they do on the front end.

AT: How long does that process take?

John: It does take time and varies from market to market.

AT: The trend has been to add various emerging markets in the last few years. Are there any sub-trends within that? What are some new areas and what does the future look like?

John: We're very committed to building up a network of markets around the world, and we go about it in a very thoughtful and systematic way. The two markets that we are focused on next would be India and Brazil, as our members have shown us their clear interest in those markets.

AT: I wanted to step back and ask what you think about the level of international dialogue with regards to regulation. What are the big issues for you?

John: First, it goes without saying that the regulatory framework is, if not the most important macro-competitive dynamic, certainly equal to the fundamental issue of flows of equity funds into actively managed products that are seeking dark crossing networks.

There are some efforts that want to take place on a global basis and then certainly there are market-by-market dynamics. It is absolutely paramount that we understand this. We have a very strong team of people engaged in this, from a global standpoint and also market by market, where we are present and active.

We think the regulators are rightly focused on assessing what has worked in the opening up of the markets that led to everything from the electronification and the fragmentation, as well as the growth of alternative trading venues. There's a great deal of benefit that has come from that. And in fact the regulators themselves have sponsored some very good empirical work that shows investors have benefited in concrete ways by seeing a narrowing of spreads and a lower cost of trading. At the same time it's clear that market structure has become overly complex, and that some of that complexity has caused problems that have understandably raised concerns by regulators and investors alike about how safe is it to trade in the markets, whether you are an institution or whether you are an individual. And so we recognise, wholly understand and are very supportive of regulatory efforts to adjust the evolution of market structure so that we can preserve the benefits of more competition, tighter spreads, lower trading costs, and find ways to reduce the problems that have certainly made it more challenging for individuals to trade, but have also made it difficult for institutions to trade.

Specifically, the two areas that tend to get - in broad, general terms - regulatory focus have to do with how crossing networks in all of their variations operate, and the proliferation of the high frequency trading phenomenon throughout the world.

On the crossing network front, there are many different types, many different flavours of them. And within the realm of dark pools aimed for traditional investment managers, our model is unique. It's different from any of the other approximately 50 dark pools in the world, and importantly it's members only.

Our model has remained unique, evidenced by the dramatic scale of average execution in any of the venues where we operate around the world. And it's also characterised by the vast preponderance of trading that is manual negotiation ... Some 90 percent of our business is transacted at the midpoint of the spread.

AT: Are there specific measures that are being discussed that you see having an impact on your business?

John: The particular issues that tend to come up revolve around, generally, regulators looking at things like a certain minimum size order above which or below which certain limitations will apply.

Most of those things are relevant to the rest of the world but are extraordinarily low thresholds relative to the very substantial crossing that goes on in our system. So, in effect, by trying to define a segment of the market by the normal metrics that prevail in dark pools, we get caught up in problems that have -

AT: - little to do with your business model.

John: Right, it's an unintended consequence, we think, that limits are placed on the ability of our members to manually negotiate trades.

AT: What sort of limits are we talking about?

John: Limits for transactions above a certain number of shares. And that's intended to generally try to avoid the problem of retail investors being overwhelmed by, or caught up in, the stomping around by elephants. A lot of those limits leave us on the wrong side of the limit.

The other limitation that is usually dealt with relates to price improvement, and when you have a system that is crossing at the midpoint, for the vast preponderance of our trades, the idea that trades above certain thresholds have to be at price improvements, for example, kind of runs roughshod over a model where we can be crossing 100,000 shares, 500,000 shares at a midpoint price.

The other thing I want to comment on is the high frequency trading, which is the other broad focus of the regulators.

Among the institutional investors with whom we do business, there's some ambivalence. Some feel strongly opposed to high frequency trading and others feel it really doesn't make much of a difference, at least nothing adverse.

In any case, one of the powerful advantages of trading in our particular dark pool is that it is HFT-free. It is pure buy-and-hold, long-term traditional, fundamentally based investors who happen to be transacting on a very large scale. So what's going on out in the external market, that's where price discovery takes place. As substantial a component of the market as it is, some feel that's helpful to helping to establish price and tight spreads. And there are others who feel, because it's divorced from fundamentals, that it's driving prices more as a function of trends and anomalies and technical discrepancies and that it's therefore disruptive to price discovery. All things considered, when we think about HFT and our members talk to us about it, it reinforces the value proposition of being able to trade in very large blocks safely within this buy side only, members only platform.

AT: So they can use the HFT activity outside Liquidnet for indicative purposes.

John: In fact, we have tools that can help them discern when the price is being driven by high frequency trading as opposed to more traditional buy-sell balances. But again, they trade here because this is where the block liquidity is. They trade here because they know they are dealing only with the natural buy side, who is not going to be gaming them.

AT: The tools you were mentioning there, what sort of tools are we talking about?

John: We have trade analytics that enable our clients to evaluate price behaviour and reach some conclusions about what might be driving price. Specifically: do we see behaviour that suggests that someone is a high frequency trader who's looking to find liquidity on one side or the other and get ahead of them?

Number of Liquidnet members globally

Number of Liquidnet members globally

AT: In the exchanges, there's been a real drop-off in terms of volumes and a lot of people have been talking about what it might take for there to be a pickup and a return of investor confidence. I'm wondering how much that affects you, because you are so different.

John: We are fundamentally very optimistic about the institutional equity market. If you think of asset allocation, actively managed traditional equities will continue to be a fixture and a very important large component of a portfolio that has any semblance of balance to it.

Second, many of the problems that have been the cause of decline in market volumes are being actively worked on and will be resolved. The big ones that come to mind, certainly in the US, are the fiscal and budgetary issues. The euro zone issues, they are persistent and troubling, but we see over time a highly focused effort and progress. If you look at the China growth story and related emerging market issues that have impacted the flow of equities, there again, they are persistent problems, they are troubling, but there's focus on them and they will get sorted out.

And the last piece of this is, remember where these equity funds come from. People the world over, even if it's at a reduced rate, continue to put money into retirement vehicles and other savings vehicles - that money has to get deployed. People continue to buy insurance policies - those premiums accumulate and have to be invested. People continue to make contributions to charities, their schools, endowments and the like - that money has to get deployed.

Look at the very low rates of some of the government bonds around the world and alongside that the pursuit of yield. Look at the high yield calendar, the increase in yield products. There's only so much appetite and capacity that investment managers and portfolio managers have to do that. So inevitably this continuing build-up of liquidity and the need to have some sense of balance in a portfolio means that we will see significant flows of capital, managed funds, back into the traditional equity product.

In the meantime, yes, our business volumes have come down in sympathy with the declining equity funds flows and volumes, but by the metrics that are publicly available, and through conversations that we have in the industry, including what we pick up through our discussions with regulators and exchanges around the world, we have done far, far better than the rest of the community. And we believe that goes back again to the core value of our buy side only, members only platform of very large blocks. When liquidity goes down, the value of large blocks goes up. And we have this distinctive profile, so that when people are desperate to find liquidity, if they rest their orders here with us they find they're more likely to get their business done as opposed to trying to fight it out in the market place.

AT: Last question. In terms of technology, are there any interesting things that you are looking at that have the power to be transformative in terms of your business model?

John: I can give you a little bit of a teaser. For the last couple of years, we have been very focused on how we create a tool on the desktop for the trader that allows them to solve their two biggest problems. One is achieving best execution, and the other is paying and managing their bills. So we have put together, alongside our core matching engine, some tools that allow our traders to do trade analysis and allow our members to pay their bills and manage them.

Bearing in mind Liquidnet's founder is the inventor of the OMS, and the OMS is now ubiquitous the world over, we'd like to think that what we're going to present is an interface that allows our members to combine their objectives of achieving best execution and management of their bills in a way that takes a step above and beyond OMS and EMS and allows them to truly just manage their liquidity.

AT: I wasn't aware that the founder had invented the OMS.

John: It's a pretty cool footnote to working at Liquidnet.