Broker of choice
Merlin Securities is a six year old introducing broker that specialises in helping hedge funds find the right prime brokerage and trading services, including access to best execution irrespective of the instrument and the execution venue. In a trading environment where a mixture of technology, regulation and infrastructural upheaval seems to have disintermediated virtually everybody except the principals to the trade, how on earth has Merlin found a role intermediating trades for hedge funds?
Today, it is cheaper to trade US equities than at any time in history. Average bid-offer spreads in US equity markets are now the tightest in the world. Institutional commissions per share are perhaps a quarter of what they were in the mid-1990s. It is not hard to see why this has happened. Even a decade ago, a trader at a fund manager would place an order with a sales-trader at a broker-dealer, who routed it to a listed trader at the broker-dealer, who called a clerk on the trading floor, who passed the order to a broker, who then executed it with the market-making specialist. The trade would then follow the same circuitous route back, with the addition of a back office intermediary to deposit the cash or securities in the account of the fund manager. Quite simply, technology has knocked four of the five people out of the chain in both directions. Dealers working for fund managers now enter trades into digital systems that sit on their desks, choosing only between going direct to an execution venue or via a third party trading desk with none of the people that used to intermediate their trades touching them at all. Or they make use of an algorithm they have either written themselves or rented from a broker-dealer, which selects the optimum blend of execution venue, volume and time period. “Yes,” says Eric Morgan, Senior Partner and Head of Trading at Merlin Securities. “Technology does mean that only the trader at the fund sees, executes, books and allocates the trades.”
So where does Merlin fit in? By offering hedge funds a choice is the short answer to that question. Merlin lets its hedge fund customers choose which trading platform they want to use, which liquidity sources they wish to access, and which trading tools they prefer to use. Merlin currently offers seven execution management systems (EMS). They are REDI from Goldman Sachs Electronic Trading, Neovest from J.P. Morgan, RealTick from Townsend Analytics, Bloomberg EMSX, the thinkpipes options trading platform now owned by TD Waterhouse, and the DIRECT TRADE on-line futures commission merchant. Since September, when Bank of America Merrill Lynch came on board as a clearing broker to Merlin clients, its InstaQuote execution management platform has also been available. “It means customers can come to us and say, `At my old shop we had RealTick.’ Can I use RealTick at Merlin?” explains Morgan. “And what we say is, `Yes, you can have RealTick,’ or `Yes, you can have REDI,’ or `Yes, you can have Neovest.’ We want to make it easy for customers to come on board, and for traders who are used to a particular system. In fact, it is not uncommon for different traders at the same firm to use different execution management systems. What we never see is the same trader using different systems. But the choice is there if they want to make it.”
That freedom to choose was written into the DNA of Merlin Securities at the outset. Morgan knows this, because he has been at the firm since it opened for business in January 2005. Somehow, he had managed to work at Montgomery Securities in the 1990s without coming across Stephan Vermut, the visionary former Montgomery prime broker who conceived and founded Merlin Securities to exploit an opportunity he saw for an independent firm that used technology to intermediate the use by hedge funds of multiple prime brokers. Doubtless that extraordinary lack of coincidence owes something to the fact that Morgan covered international institutions rather than prime brokerage accounts. Morgan stayed at Montgomery through its acquisition by NationsBank in 1997, and the merger a year later of NationsBank with Bank of America. He switched to Susquehanna in 2002, where he started a desk trading derivatives and ETFs for hedge funds. That exposure to the hedge fund industry endowed Morgan with the experience that persuaded Steve Vermut to invite him in late 2004 to open the trading desk at Merlin Securities. “When I say I started a trading desk for Merlin at the beginning of 2005, I mean it was just me trading for one or two clients,” recalls Morgan. “But as we brought clients on board we continued to build out the trading desk.” He now heads a team of 15 traders executing trades on behalf of 450 hedge funds, including Asian and European markets, which means operating around the clock. Morgan reckons they handle 30 per cent of daily trading volumes processed by Merlin. The rest are submitted electronically through one of the EMS systems.
An EMS is of course no more than a route to market. Direct market access (DMA) is available through the Merlin memberships of NYSE Arca, NASDAQ, BATS and DirectEdge, which the firm regards as the four most important equity trading venues besides the New York Stock Exchange (NYSE) itself. Merlin has understandably decided to forgo the costs and regulatory complexities of direct membership of the NYSE, but clients active on the exchange can go through any one of the three clearing brokers used by the firm. “There is really no benefit for us being a member of the NYSE,” says Morgan. “It is not only expensive but entails a great deal more regulatory compliance as well.” Merlin also relies on its clearing brokers to clear and settle trades in markets outside the United States, though trades are typically directed to the various exchanges through Credit Suisse, Instinet and some local brokerage firms as well as Goldman Sachs and J.P. Morgan as clearing brokers. The firm currently offers execution in 96 different markets around the world. “We can trade in even more markets, but the real question is, `Can our clearing broker clear in these markets?’” explains Morgan. “With J.P. Morgan, we can clear in 96 separate countries, and that sets the limits to our coverage.”
Unlimited geographical reach is not yet essential, but is increasingly important. At the moment, a high proportion of the transaction volumes passing through Merlin are in US domestic instruments only, and the bulk even of European volumes go no further than London. Likewise, the majority of Asian business is concentrated in Hong Kong and Tokyo. “The majority of our business is still done in the US, but we continue to grow that business nicely as we grow the firm,” says Morgan. “However, as the firm grows, and we take on different types of hedge fund, our clients increasingly venture outside the United States as well. A lot of the hedge funds we cover today are still long/short US equity funds, but even they are increasingly looking for alpha outside the United States. I am also seeing more and more hedge funds coming to Merlin that are Japan only, or Asia only, or European only.” Asset classes are diversifying too. In fact, Merlin has added futures and commodities trading to its repertoire, and not only through its exchange memberships and the seven EMS, but also via Goldman Sachs and MF Global. The firm is now registered as a broker with the National Futures Association (NFA). With clients using equity futures and options to hedge their portfolios, Merlin has two dedicated derivatives traders. Fixed income trading remains a minority interest, though Merlin does trade the instruments for customers.
What is developing fast is algorithmic trading. “Of the 70 per cent of order flow that is submitted to Merlin electronically, 60 to 65 per cent is now traded algorithmically,” says Morgan. “Algorithms have gotten so much smarter today. It is no longer just VWAP or Percentage Volume type orders. Algorithms now look at illiquid names, and only go out to dark pools, or exchanges where stock is trading, and never post anything there – only search for liquidity. They are helping the dealers at the funds find liquidity they could not even search for before.” He argues that algorithms have overcome the fragmentation of equity trading occasioned by the development of order-driven electronic trading platforms, crossing networks and dark pools that compete with the traditional stock exchanges. “The algorithms go out to all of the exchanges, all of the trading platform, and all of the dark pools, and even go out to the liquidity pools controlled by other algorithmic trading providers,” explains Morgan. “They are effectively pulling all of these sources of liquidity together. Algorithms take the fragmented equity market and pull it all back together. You almost have to make use of algorithms to make sure you are hitting all of the different liquidity sources.”
Merlin currently offers access to algorithms from Bank of America Merrill Lynch, Barclays Capital, Bloomberg, Citi , Goldman Sachs, ITG, J.P. Morgan, Knight and UBS. But how do Merlin traders help Merlin clients choose between competing algorithms? “Each one of these different algorithmic providers has their little tweak or specialty, but what I like to look at is where the liquidity is,” explains Morgan. Data collated (though rarely published in full) by Greenwich Associates and TABB Group suggests that a small number of firms – Credit Suisse, Goldman Sachs and Knight – dominate algorithmic trading volumes. Trade cost analyses usually identify much the same firms as the most cost-effective. Merlin submits all of its client trading data to Elkins McSherry, the transaction cost analysts owned by State Street, which analyse costs by both customer and execution venue. Clients get their own Elkins McSherry report for free from Merlin, but the firm itself also pores over the findings. “We look at the arrival price and the interval VWAP, so we get a sense of how we did when we finish the order against the price at the time we received the order,” explains Morgan. “So I can compare Credit Suisse, Goldman, Knight and others as execution sources, irrespective of what our clients were seeking to do, against those two benchmarks. I do not find much difference between them, but what I do find is that the other firms miss the benchmarks.”
What explains this difference between the market leaders and the also-rans? Again, the answer lies in the verdict Morgan offers: they have the best access to liquidity. Certainly, the regular data published by Rosenblatt Securities suggests that Credit Suisse, Goldman Sachs and Knight are picking up the largest shares of dark pool volumes. “If you know where the liquidity is, the algorithm is going to work much better, because they know where to find it, through their dark pools,” adds Morgan. “Credit Suisse, Goldman, Knight and UBS are the four top algorithmic providers we offer our customers, and the reason for that is that they have the liquidity, mainly because they have a lot of retail as well as institutional flow. We want to get the best price for our customers, and how can we better source that best price than by finding where the liquidity is?” In that sense, algorithms have not changed anything fundamental in the US equity markets – in effect, the major market makers are now the major algorithmic providers – but they have certainly made those markets more efficient. “A computer is now matching up those trades, instead of a market-maker matching up those trades,” says Morgan.
This prompts again the question that will not go away: where exactly is Merlin adding value in the execution sphere? “We simply try to give our customers what they want,” explains Morgan. “We have the same open architecture on the trading desk as we do throughout the whole firm. So our customers have a choice of seven different execution management systems, nine different algorithmic providers, and of more than 30 dark pools.” Merlin also offers choice in the post-trade area. Clients can choose between four separate clearing brokers (J.P. Morgan, Goldman Sachs, Bank of America Merrill Lynch and National Bank of Canada) and one independent custodian (Northern Trust). If the same customers went to, say, Credit Suisse, their choices would be restricted to the liquidity venues accessed by Credit Suisse Advanced Execution Services plus the Credit Suisse clearing and custody services. The FIX-enabled Merlin technology eliminates the data management advantage of a single provider by tracking transactions in real-time as they flow from execution through clearing to reporting, allocation and custody. The major broker-dealing houses are happy to access the clients indirectly too, because they gain a portion of the liquidity provided by the 450 hedge fund clients of Merlin Securities – which in turn helps their algorithms to outpace the competition. “They are in a market share or volume game, in which they want to attract as much liquidity as possible into their dark pools and algorithms,” explains Morgan. ”And what we want to do is give our customers a choice. By going through Merlin, they can have access to multiple algorithmic providers. If they go direct, they cannot.”