Canada STA 2015 Market Making and Liquidity Provision in Modern Markets Phil Mackintosh
2 What am I going to talk about? Why are Modern Markets Important?
Trading is now physics at the speed of light
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% 500 2 Bn 14% 0.00% 0 Bn 0% Source: KCG Estimates
Automation has benefitted all sorts of investors Source: KCG Estimates
Most HFT is good Source: Tabb
7 What am I going to talk about? Market Making and Liquidity Provision
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 $20.00.01.02.03.04.05.06.07.08.09.10.11 $20.12 Bid Offer
Liquidity Provision 101: The market makers perspective Market Maker Profit: -5 cents x 500 = $25.00-4 cents x 500 = $20.00-3 cents x 500 = $15.00-2 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 $20.00.01.02.03.04.05.06.07.08.09.10.11 $20.12 Bid Offer
This is why queue priority is so important Profit Loss Source: KCG
From the perspective of the market maker
Spreads seem to rationally widen using Black Scholes Source: KCG
13 What am I going to talk about? Why is Speed so Important?
Shouldn t market makers be obligated to provide liquidity? Source: Bloomberg
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
Is There a (Message) Traffic Problem? Source: FINRA
17 What am I going to talk about? What do Academics Say?
Liquidity Provision 101: The academics perspective
Academic results We find that: o HFT react quickly to big trades can be seen as a way of playing defense against informed investors
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.
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 What am I going to talk about? Do Investors Benefit from Speed?
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
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
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
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
But it s just physics
28 What am I going to talk about? What Does This Mean for Naturals?
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
Routing is a trade-off Seller for 1000 Dark Pool 1 Dark Pool 2 Buyer for 500 $20.00.01.02.03.04.05.06.07.08.09.10.11 $20.12 Bid Offer
Lit vs Dark is a trade-off Source: KCG
Lit vs dark is a trade-off ISO/IOC/ Market 20% Non Displayed 29% Displayed 51% Source: KCG
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
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