In the Clear: Merrill Sets Back-Office Deal With Knight/Trimark

The agreement, to be announced this week, has bigger implications for its dissimilar partners.
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In a union of tradition and transformation,

Merrill Lynch

(MER)

agreed to start handling the back-office end of stock trades for

Knight/Trimark

(NITE)

in a deal that promises to have larger implications for the brokerage firms.

After four weeks of discussions, three executives close to the deal say, Merrill's

Broadcort Capital

unit will begin clearing trades in mid-October for the institutional brokerage and market-making operations of Knight, one of the largest

Nasdaq

market makers and a behind-the-scenes power in online trading and Internet stock traffic. Market makers ensure that buy and sell orders from investors get completed, often taking the other side of trades themselves.

The agreement, reached last week, is expected to be announced this week.

While brokerage-clearing agreements include record-keeping, trade confirmation and other back-office tasks that involve about as much excitement as a

Barbra Streisand movie, the move by Merrill to bring Knight into its fold is a nod to the power of Wall Street's new electronic elite. The two may at some point forge stronger relationships in international operations and after-hours trading, the executives say.

"It's a clearing relationship first, with other strategic relationship potential," says one of the executives close to the deal. The deal doesn't involve an ownership stake.

"Merrill clearly wants a piece of the burgeoning Net trading market," says independent industry analyst Michael Flanagan. "What's becoming popular is for larger firms, such as Merrill, to establish positions in businesses that may grow, many of which Knight is already established in."

Goldman Sachs

(GS) - Get Report

is the most glowing example of this phenomenon. It has bought stakes in online brokerage

Wit Capital

(WITC)

and electronic communications network

Archipelago

. It formed a partnership with, among others, Merrill in electronic trading system

Primex

and has agreed to acquire

Hull Trading

, an options firm with experience on Europe's electronic markets, for $531 million.

So Merrill, suddenly, is in hot pursuit. It has rolled out an online trading option for its retail clients, and the deal with Knight shows its desire to be a player in the trends that have driven the market since late 1997. Knight is the primary market maker for the online brokerage community, and the relationship gives Merrill, at the very least, a small slice of a business in which it's not directly involved.

In addition, as Merrill rolls out its low-cost online trading product for retail investors, it also could use Knight as a market maker in those trades.

For Knight, the deal represents an opportunity to bolster its international expansion. The firm recently acquired an 18.9% stake in

Easdaq

, a European version of Nasdaq, and has planned to expand its international operations by early 2000. If Knight can leverage the clearing relationship further, Merrill's global institutional and retail client base could provide a steady source of liquidity for the new project.

One Knight executive who asked to remain anonymous says the Merrill package even carries the potential to help the firms with the infant after-hours trading, given Merrill's customer base and Knight's market-making operations. A relationship with Merrill gives Knight potential access to order flow from the firm, providing a buffer against any slowdown in the online-trading world.

In June, Knight held a 17% market share in Nasdaq securities trading, according to the

AutEx Group

, making it the largest market-making firm for those issues, and a 6.4% market share in

New York Stock Exchange

-listed securities. Knight averaged 340,000 trades a day during the second quarter.

For that kind of volume, Merrill was willing to charge bargain-basement prices. Two executives close to the deal say Knight will pay less than $1 a trade, well below the industry standard of $4 to $7 for this kind of business, and what it was paying with

PaineWebber

(PWJ)

, its clearing firm since March 1998.

Another possibility -- albeit a long shot -- for expansion of the relationship is electronic options trading. Knight is one of the founding investors in the

International Securities Exchange

, the first electronic options platform, and has already exercised its ownership option into "seats" on the system. Stronger ties to Knight could result in Merrill sending order flow to ISE, set to begin trading in the first quarter of 2000.

At this point, of course, all is conjecture. The firms are just now planning the switch and a big move isn't likely to come too soon afterward. But on a Wall Street that finds itself in historic flux, the firms will likely nurture any evident synergy. "Not many firms know where the industry is headed," says Flanagan, the independent analyst. "They want to make sure they have a piece of whatever direction it goes. They're covering all the potential bases."