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Why Be A Market Maker When You Can Just Be A HFT Scalper?

Tyler Durden's picture





 

One of the key underreported news from yesterday was this tidbit by the WSJ, which highlighted that the head of Interactive Brokers Group Inc. said that his firm's market-making unit may withdraw from some options markets or even convert into a high-frequency trading firm because of what the company views as an unfair regulatory regime. In other words, the current regime rewards HFTs and punishes standard prop traders. (As a reminder IB's Timber Hill market making algo is precisely what two Norwegians gamed in 2007 and 2008 to make enough profits to get them in court and facing a 6 year prison sentence). To an extent this should answer Michael Lewis' rhetorical questions posed yesterday in Bloomberg, as to why Wall Street firms are voluntarily eliminating their prop trading divisions. The simplest answer: everyone is entering the scalping business, with some already having a material advantage over others. As to what this means for the market, the answer is another virtually assured flash crash: "If [regulators] do not make it sufficiently attractive for us to continue as market makers, then we will probably selectively deregister," Peterffy said in an interview. "Potentially we could even become a high-frequency trading firm ourselves, and provide liquidity when it is in our interest." And it gets worse.

 "We are discontinuing some business where there is practically no trading," said Peterffy. "Once the SEC comes out with the new rules [for high frequency traders], we'll examine whether we need to make a bigger change, or not."

Peterffy said that Interactive Brokers continuously maintains about 500,000 bids and offers in various markets around the world. He said the firm sometimes finds itself at a disadvantage to smaller competitors that operate with fewer regulatory restrictions and are able to move more quickly.

When market conditions change, it takes Interactive Brokers some time to adjust all of its quoted prices, he said. High-speed trading shops that are not registered market makers are able to selectively choose where to trade and outpace firms like Interactive Brokers that carry obligations to be in many markets, according to Peterffy.

The cannibalization of profits courtesy of HFT means very soon everyone will be an HFT! And when that happens, virtually everyone will be on the same side of the trade, until there is a regime change and everyone rushes to the other side, which according to many is precisely what happened on May 6, when the market went bidless. So yes, this is exactly what will happen once again, as more and more of Wall Street realizes that this last loophole to eeking out a few extra pennies per trade is the only place to be. What happens next is anyone's guess, although as the following guest post from Wall St. Cheat Sheet explains, it won't be pretty.

Guest Post From Wall St. Cheat Sheet

Why Trade Prop When You Can Just High Frequency Trade?

In my recent writeup on the Myth of the Missing Volume
I included a prelude to one of my recent thoughts: the notion that
banks are abandoning proprietary trading not exclusively for regulatory
compliance under the new Dodd-Frank Bill, but rather because it’s a
failing business.  This is what I had to say:

As far as structural changes go, a funny thing happened
on the way to global economic meltdown: prop desks who flipped stocks
minutes at a time were replaced with computers who flip stocks by the
second.  Major institutions like Goldman Sachs (NYSE: GS) are closing down their prop desks,
while their HFT shops continue to rake in the profits.  Don’t believe
all the rhetoric that this is solely a consequence of the Volcker Rule
in the new financial regulations.  A lot of that discussion is
political grandstanding in the quest for more favorable compromises out
of regulators. Prop desks enjoyed a great run in the midst of the epic
volatility storm that wreaked havoc on our economy; however, in the
storm’s wake, these desks have struggled mightily.  In reality, this
new transition has as much to do with the fact that proprietary trading
takes on more risk and results in lower profits than the high frequency
variety in today’s markets.  At the end of the day, it’s simply good business to shift to HFT.

Today, econ-journalist heavyweight, Michael Lewis is out with his own take on the “Mystery of Disappearing Proprietary Traders” that is absolutely worth a read.  The mystery begins as follows:

The 3 percent loophole amounted to an invitation for the
big banks to keep on doing at least some of what they had been doing —
which is why Levin felt compelled to remove it, and the banks fought so
hard to keep it.

Yet in just the past few weeks news has leaked that Morgan Stanley,
JPMorgan and Goldman Sachs all intend either to close their proprietary
trading units or to sell their interests in the hedge funds they
control.

So the banks had an opening to maintain a larger interest in
proprietary trading; however, despite that regulatory loophole the big
banks are not seizing the opportunity.  I repeat, DESPITE A LOOPHOLE,
the banks are not seizing an opportunity.  And this is a sizeable
opportunity to boot.  3% of capital for a big bank is a substantial sum.
  You know what passing on this “opportunity” means?  It means
obviously that there is not the opportunity there that many imagined. 
Lewis offers two possible explanations for why exactly that is:

No. 1 — Having not merely preserved but bolstered their
place at the heart of capitalism — with little banks failing everywhere,
the big keep getting bigger and stronger — the major Wall Street firms
have experienced an epiphany about their relationship to wider society.
They don’t need to screw people!

Newly able to raise their prices, they want to return to serving their customers, rather than exploiting them.

No. 2 — The big Wall Street firms have looked anew at proprietary trading and seen a dying business.

And I largely agree on both fronts, particularly with the second
point.  If the banks saw an opportunity to make money, they would seize
upon that opportunity despite the ability to garner increased revenues
from traditional investment banking operations.   I think to a
significant extent what is happening right now, at least in equity
markets in particular, is a transition from traditional “proprietary
trading” to the more vague “market-making operations.”

And by market-making operations I am specifically alluding to high
frequency trading.  A bank like Goldman can actually increase their VAR
(value at risk) while taking less “real” risk using HFT and can remain
as active as ever in equity markets without even having a proprietary
trading division.  There are many types of HFT strategies (I urge you
all to check out this great chart from Brandon on the six primary strategies of HFT)
and it’s rather difficult for market participants and regulators alike
to distinguish how exactly algorithmic volume is being dispersed across
markets.  Why engage in “proprietary” trading when one can conduct a
very similar business under the veil of “market making” and high
frequency trading?

Since this “mystery” is in the early stages of its evolution, it
remains to be seen exactly what big bank trading will look like in the
coming months and years, but don’t be fooled into believing that banks
are simply leaving the proprietary business because regulators told them
to.  The banks had the opening they needed to maintain that line of
business and that’s all it is to them: a line of business.  At the
moment it is a particularly risky business with diminishing profits, and
that alone is why banks are abandoning those operations.

Just a personal note to conclude my writeup for this morning: this
weekend I will be getting married to my wonderful fiance Emily.  For the
next two weeks the two of us will be off on our honeymoon; therefore,
my morning write-ups will be on hold until my return.  Have a great
couple of weeks!

 


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Thu, 09/30/2010 - 09:49 | Link to Comment Lenny
Lenny's picture

Where are the adults?

Thu, 09/30/2010 - 09:51 | Link to Comment Plainview
Plainview's picture

This is entirely predictable and an utter shambles.

Binary liquidity is where we are headed: 0 or 1.

Thu, 09/30/2010 - 09:51 | Link to Comment RobotTrader
RobotTrader's picture

Bears are getting destroyed today.

More and more sectors are taking off.

Must be those HFT algos.

Thu, 09/30/2010 - 10:26 | Link to Comment Tyler Durden
Tyler Durden's picture

Robo, you really have a knack at top ticking stuff.

Thu, 09/30/2010 - 11:01 | Link to Comment Hephasteus
Hephasteus's picture

Man. Stop it. I was using jonny as a tell for when gold breakout was imminent. Now you're messing up the stock junkies tell.

Fear and confidence. It's whats for dinner.

Thu, 09/30/2010 - 11:04 | Link to Comment thepigman
thepigman's picture

I would get in on this

dip, Robo. Be a

stage 3 parabola

buyer. Secret to vast

wealth.

Thu, 09/30/2010 - 12:00 | Link to Comment Hephasteus
Thu, 09/30/2010 - 11:14 | Link to Comment Tell me lies
Tell me lies's picture

Robot, I am a fan because the whole point of this exercise is to make$$ or was it that fight club ting? I am on the sidlines and scared to go long and been squeezed on the short. What do you see happening near term?

I like the oil play but a little rich for me now.

Thu, 09/30/2010 - 10:04 | Link to Comment sbenard
sbenard's picture

I have been using Interactive Brokers for years. I wonder now if I should jump ship!

Thu, 09/30/2010 - 10:04 | Link to Comment Bob
Bob's picture

Hey, CONGRATS, Tyler!  Best wishes, man. 

Thu, 09/30/2010 - 11:55 | Link to Comment traderjoe
traderjoe's picture

Hey Tyler, is it you getting married or was this a guest post? Congrats. Where are you registered - I'll get you the gravy boat and ladle. I love getting the gravy boat and ladle - both useful and a little odd at the same time. And everyone asks for a set. 

If I don't hear from you, I'll drop a donation in the box. You do take FRN's don't you?

Thu, 09/30/2010 - 10:05 | Link to Comment Djirk
Djirk's picture

Bye bye you front running snot nosed pirate sell side scum bags!

dark pools bitchez!

 

Enjoy your honeymoon!

Thu, 09/30/2010 - 11:06 | Link to Comment kato
kato's picture

you = gay

Thu, 09/30/2010 - 10:06 | Link to Comment ToNYC
ToNYC's picture

I suppose the SEC is waiting to see where the Banks and Broker Dealers are going so they can pretend to notice and await the political wind to put up another net to catch the wind. Meanwhile back in the real world, the regulators would preserve the blood by starting with a tourniquet, and bring back the human time frame for whom the real deals are done.

Thu, 09/30/2010 - 10:09 | Link to Comment Cognitive Dissonance
Cognitive Dissonance's picture

As to what this means for the market, the answer is another virtually assured flash crash:

Tyler baby,

I would appreciate it if you could tell me when the next flash crash is coming. It's getting mighty expensive popping popcorn all day to ensure there's a fresh bowl ready at all times. I mean, when the crash comes, there'll be no time to pop the corn since it will be all over in 12 minutes tops.

Please, give us a clue. I just went through an IRS audit and they didn't like my $934.82 deduction for popcorn. They said it was entertainment and not business.

Thu, 09/30/2010 - 10:11 | Link to Comment Samsonov
Samsonov's picture

I'm a low frequency trader who simply owns stocks; I don't buy leveraged ETFs, mess with calls or puts, use stops, or buy anything I don't understand (ahem, GLD).  So I don't see how all those shennanigans affect me at all, for instance the last flash crash during which I was in a meeting and it was all over with practically no ill effect on me at all by the time I got back to the screen.  It's almost like my market is a different place from their market.

Thu, 09/30/2010 - 10:40 | Link to Comment Xedus129
Xedus129's picture

As long as after it crashes it comes back up :)

Thu, 09/30/2010 - 11:02 | Link to Comment Trifecta Man
Trifecta Man's picture

If you used stops to limit your downside on a particular stock, your stop could have been executed at a low price, and then return towards its prior value in a short time.  That is how it could affect you adversely.  FYI.

Thu, 09/30/2010 - 11:27 | Link to Comment Tell me lies
Tell me lies's picture

If you are under the "15%" threshold, your stops will be executed and thus flushed out of your position with no recourse?????

Thu, 09/30/2010 - 12:02 | Link to Comment Samsonov
Samsonov's picture

I don't use stops for this very reason, so it's irrelevant to me.  Look, no matter what you invest in, you have to guess right.  If it's a stock, you are betting on one variable.  If it's a stock with a stop limit, now you are betting on two variables.  The more complicated, the more variables, the more random.  Why make things more complicated than they already are?

Thu, 09/30/2010 - 10:14 | Link to Comment Bearster
Bearster's picture

It looks like the regulatory failure is that regulation coercively creates a disadvantage to those companies labelled "market maker".  So the solution is to coercively create even more disadvantage for those labelled "HFT"??

By the way, the market maker is not there to buy what no one else wants to buy, and no regulation can force them to get in front of a steamroller.  The market maker, therefore, cannot keep a market from going bidless.  The market maker narrows the bid-ask spread.

If the market goes "no bid" that is because of stress, or fear, crisis ... or perhaps people are starting to realize that everything is badly overpriced.

Thu, 09/30/2010 - 10:16 | Link to Comment wcvarones
wcvarones's picture

Similarly, why be a business/consumer lending bank when you can just ride the Treasury curve with free Fed money?

Thu, 09/30/2010 - 11:11 | Link to Comment badnews...buyspus
badnews...buyspus's picture

The hft game will end only when the exchanges STOP paying rebates. Everyone in this negative externality game has NO benefit in ending it. Like all new money making schemes, it will not end until it breaks or gets shutdown(think AIG writing insurance or lenders allowing for 100% financing to a sub-600 credit score). The exchanges want to see more volume for fees (non-rebate trades), the SEC likes the apparently smaller bid/ask spreads bc the hfts have convinced them that they provide liquidity driving down spreads and costs (yes, for a 100 shares, but for the 10,000 shares you need to trade, it will cost you much more), and almost every ws firm has a hft group making good money. So, no one will step forward and call for an end. If you can't beat them, join 'em (IB). Once again, ws is near-sighted and will be hurt in the end as more and more investors (myself included) will never invest in a publically traded company while this game is played bc stock prices are just numbers and therefore companies can't be valued on the open markets. Since, all hfts view the rebate as their profit potential (scalping is just gravy), make it go away and so will the hfts.

Once again, you are a contrarian getting married while marriage numbers continue to decline - congrats.

 

Thu, 09/30/2010 - 11:44 | Link to Comment Vampyroteuthis ...
Vampyroteuthis infernalis's picture

This reminds me of the rounding scam in the movie Office Space. Rob the market a few pennies at a time. No one will notice until a large amount of money vanishes. The only problem is the HFTs are legal in the market.

Thu, 09/30/2010 - 13:59 | Link to Comment MarketFox
MarketFox's picture

Let's make this simple....

Defragment all exhanges ...to the BATS model....

No market makers...

The exchange charges service only....

ie...  .0001

Then let the players do what they will....

The core exchange is secure....and in service....add on only mode....

...............................

Since when do MMs give away money ?

Nobody gives away money....except the FED....

......................

Next....ONE SECOND MINIMUM....

......................

Next....no min acct size....

There will be large size limits....

No short sale rules....limited to shares authorized....via electronic tag....

...............................

The exchange just becomes a utility company....not interested in gaming anybody.....

...............................

Also all participants pay the same .0002 commission rate....no exceptions as to the size of each account...

........................

Next...banks cannot game RETAIL...only allowed to service RETAIL...

..........................

Next....the focus should be getting rid of the massive size accounts that have heavy influences....

All goes RETAIL....2 BILLION hopefuls....getting their info. from wiki based format.....

...............................

And with no interest payments left....a 20 cents move in a $10 dollar stock....is 20X the annual rate paid otherwise....

........................

Everybody becomes a trader....not by choice....but by lack of other options....

..........................

INTERNET AGE....NOT STONE AGE....

 

Thu, 09/30/2010 - 14:19 | Link to Comment cowdiddly
cowdiddly's picture

Congratulations Tyler, on your upcoming wedding. May you live a long and prosperous life. If this in fact a statement about you and not a guest post.

Thu, 09/30/2010 - 14:51 | Link to Comment TraderTimm
TraderTimm's picture

High Frequency Trading is on the way to becoming the 'herpes-simplex' of the market. Dang thing will dig in there and *never* go away. Really wondering what the market will look like in a few years if ineffectual regulation (if any) comes about. 90% of market volumes? What the hell will that turn out to be? A frickin square-wave?

Thu, 09/30/2010 - 18:43 | Link to Comment ViewfromUnderth...
ViewfromUndertheBridge's picture

Emily (hearts) Elliot not Tyler....and the late added attribution (without explanation) means no one gets the gravy boat with ladle...

Worthwhile reading the link expaining low volume melt-ups too.

Sat, 10/09/2010 - 09:37 | Link to Comment senthil456
senthil456's picture

There are certainly a lot of details like that to take into consideration.I read and understand the entire article and I really enjoyed it to be honest.
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