Market Making and Liquidity Provision in Modern Markets

Transcription

1 Canada STA 2015 Market Making and Liquidity Provision in Modern Markets Phil Mackintosh

2 2 What am I going to talk about? Why are Modern Markets Important?

3 Trading is now physics at the speed of light

4 Jan 93 Nov 93 Sep 94 Jul 95 May 96 Mar 97 Jan 98 Nov 98 Sep 99 Jul 00 May 01 Mar 02 Jan 03 Nov 03 Sep 04 Jul 05 May 06 Mar 07 Jan 08 Nov 08 Sep 09 Jul 10 May 11 Mar 12 Jan 13 Nov 13 Automation has benefitted all sorts of investors % of HFT/EMM trading 1.20% 2,500 Institutional cost Shares/day (B) 0.96% 2,000 Sh/trade Trades/sec 14 Bn 12 Bn 10 Bn 70% 56% 0.72% 1,500 8 Bn 42% 0.48% 1,000 6 Bn 28% 4 Bn 0.24% Bn 14% 0.00% 0 Bn 0% Source: KCG Estimates

5 Automation has benefitted all sorts of investors Source: KCG Estimates

6 Most HFT is good Source: Tabb

7 7 What am I going to talk about? Market Making and Liquidity Provision

8 Liquidity Provision 101: The buy-side perspective Seller for 100 Market Maker Profit: 1 cents x 300 = $3.00 (before costs) Buyer for 100 Buyer for 100 Buyer for 100 Seller for 100 Seller for 100 Market Maker Position: FLAT $ $20.12 Bid Offer

9 Liquidity Provision 101: The market makers perspective Market Maker Profit: -5 cents x 500 = $ cents x 500 = $ cents x 500 = $ cents x 500 = $10.00 Loss $70.00 (before costs) Seller for 10,000 9,000 8,500 9,500 8,000 Market Maker Position: +2,000 shares Price Momentum: Down $ $20.12 Bid Offer

10 This is why queue priority is so important Profit Loss Source: KCG

11 From the perspective of the market maker

12 Spreads seem to rationally widen using Black Scholes Source: KCG

13 13 What am I going to talk about? Why is Speed so Important?

14 Shouldn t market makers be obligated to provide liquidity? Source: Bloomberg

15 Shouldn t market makers be obligated to provide liquidity? Exponentially difficult for market makers Every stock has Puts and calls Each put and call has OTM, ATM, ITM strikes Each strike has different terms to maturity Each contract needs a bid & offer Currently are 12 exchanges (+1 more shortly) For example, IBM has over 250 options requiring 6000 quotes

16 Is There a (Message) Traffic Problem? Source: FINRA

17 17 What am I going to talk about? What do Academics Say?

18 Liquidity Provision 101: The academics perspective

19 Academic results We find that: o HFT react quickly to big trades can be seen as a way of playing defense against informed investors

20 Academic results Argue that in fact HFT proprietary traders remain active during a crisis because: o they are able to keep adverse costs under control. o proprietary traders conduct risky arbitrage. o prop traders (fast and slow) are more profitable because they are able to take contrarian positions o Thus, by absorbing selling or buying pressure, they tend to stabilize the market.

21 Academic results We find that o HFTs provide liquidity the order in the first hour o But sometimes turn around in the case of multi-hour executions. o Institutional trading cost is 39% lower when HFTs provide liquidity o But are 64% higher when they go with it.

22 22 What am I going to talk about? Do Investors Benefit from Speed?

23 Stock Spread ETF & Futures investors benefit from High Frequency markets Trading costs Arbitrage Zone Basket Offer ETF Offer ETF Bid ETF Spread ETF NAV Stock Last Arbitrage Zone Basket Bid

24 9:30 AM 10:00 AM 10:30 AM 11:00 AM 11:30 AM 12:00 PM 12:30 PM 1:00 PM 1:30 PM 2:00 PM 2:30 PM 3:00 PM 3:30 PM 4:00 PM ETF & Futures investors benefit from High Frequency markets QQQ Basket Offer ETF Trades QQQ Basket Bid Source: KCG

25 9:57 AM 10:27 AM 10:57 AM 11:27 AM 11:57 AM 12:27 AM 12:57 AM 1:28 PM 1:58 PM 2:28 PM 2:58 PM 3:28 PM 3:59 PM ETF & Futures investors benefit from competitive markets 100% 90% ETF Rich Mid-Spread ETF Cheap 80% 70% 60% 50% 40% 30% 20% 10% 0% Source: KCG

26 Speed has always been an unfair advantage 1676: Ole Rømer first demonstrated that light travels at a finite speed 1832: Electronic telegraph was invented 1903: NYSE Floor Opened 2007: Reg NMS Protected Quote

27 But it s just physics

28 28 What am I going to talk about? What Does This Mean for Naturals?

29 Fill Rate (% NBBO Size Captured) Speed is important for long term traders too 120% Lit only Lit + Dark 110% 100% 90% 80% 80% 90% 100% 110% 120% 135% Trade (% NBBO Size) Source: KCG

30 Routing is a trade-off Seller for 1000 Dark Pool 1 Dark Pool 2 Buyer for 500 $ $20.12 Bid Offer

31 Lit vs Dark is a trade-off Source: KCG

32 Lit vs dark is a trade-off ISO/IOC/ Market 20% Non Displayed 29% Displayed 51% Source: KCG

33 4 Key Points: Understand the market Makers perspective 1. Liquidity providers want to make markets 2. But to stay in business they need to avoid big losses 3. Sometimes that means avoiding you 4. Unless you can trade in a way they can stay hedged

34 Thank you. This material is not research and is not intended as such. It has been produced by personnel employed within the Trading Strategy Department and/or by Sales and Trading personnel of KCG Americas LLC ( KCGA ). This material is intended only for clients of KCG Holdings, Inc. and its subsidiaries (collectively KCG ). It is not intended for further dissemination in its present form or any other and may not be further disseminated beyond the initial recipient without express consent from KCG. This material is not intended to constitute an offer, or solicitation of an offer, to purchase or sell any security or financial instruments or to participate in any investment strategy. The securities and strategies referenced in this material are not intended as recommendations and may not be suitable for you. KCGA believes that the information contained herein is accurate but does not warrant that is accurate, complete or up to date. The views expressed herein are based on assumptions. Any of those assumptions may be incorrect. KCG does not guarantee the performance or success of any opinion or idea expressed in the information. KCG assumes no liability to anyone as a result of the use of this material. This material provides the observations and views of the persons who prepared the material. These observations and views may be different from, or inconsistent with, the views of KCG or other Departments or persons within KCG. The observations and views expressed in this material may change at any time without notice. KCGA makes markets and trades for its own account and may hold positions in any of the securities of the issuers referred to herein or in related financial instruments. The persons who prepared this material may also advise our trading desks. In the US, products and services are offered by KCGA, member FINRA/SIPC. In Europe, products and services are offered by KCG Europe Limited ( KCGEL ) which is authorized and regulated by the FCA. KCGA and KCGEL are affiliates and are indirect subsidiaries of KCG. For additional information about KCG (NYSE: Euronext: KCG) please visit KCG Holdings, Inc. All rights reserved.