2σ’s Market Making Book: Hiding in Plain Sight

Image Credit: Liu Bolin, Museo Enzo Ferrari

~ There is infinitely more than just the devil in the details. ~ Ludwig Mies van der Rohe

It is so often said, offhandedly and seemingly without much regard for the underlying meaning, that the devil is in the details. Ever wonder about the origin of this saying? I suppose this might be a silly question for those of who commonly say things without thinking, but it’s still one worth pondering…

Famed architect, Mies van der Rohe, is credited with the origin of the quote, but this is not his original version. The original quote, which I have further paraphrased in our opening for purposes that you will soon understand, was: “God is in the details.” 

Now, as someone who has always thrived on the value of details – and sometimes criticized for getting stuck in the weeds – this last version of the quote, which I reinterpret for my own purposes as “opportunity is in the details,” has always come naturally. I didn’t need a famous architect to tell me about the value hidden in the details, but it’s comforting to know I’m not alone in thinking this way…

Homework Game: Next time someone says that the devil is in the details, consider that the opposite might also be true. (Extra credit: Shoot me a note when this happens… Eventually, it will.)

In any case, with these opening thoughts as foundation, let’s begin the totally improbable pivot into our exploration of the legendary quant shop’s, Two Sigma (2σ), market making operation – known as Two Sigma Securities – with a brief summary of Alphacution’s recent research interests as a backdrop: Our primary research mission since inception has been to develop empirical models for the impact of technology on the global financial ecosystem. We started with the largest banks in the world.

For the past year, our focus – now well into the realm of obsession – has been on the full range of buyside players (and their stakeholders): from the largest asset managers to a spectrum of hedge fund managers to an exclusive roster of small and secretive proprietary trading firms, and finally, to the highest turnover strategies in and around market making. We have approached the landscape this way because it turns out that all of these players live and operate at different points along a single continuum.

As such, a key finding from those efforts has been that the impact of workflow automation on the structural alpha zone (where market making and other hi-speed trading strategies live) is like a wave that is washing over the active and passive management zones (where hedge funds and traditional asset managers typically reside) along that continuum. Moreover, in some cases, this driver has already and will continue to represent existential threats. Refer to The Privatization of Alpha and What Does Citadel* Spend on Technology? for examples of additional background content.

Most recently, we have added analysis of 13F reporting to the mix and the discovery of this data has exploded into a series of articles containing never-seen-before details about some of the most legendary and secretive players in the world of trading and asset management – including some early peeks at the likes of Goldman Sachs, Citadel Securities (Teasers #1 and #2), and Flow Traders – where we have begun to take a closer look at the evolution of various players’ trading strategies and the hints of competitive impacts they potentially represent.

For this post, we want to combine an analysis of the data found primarily in SEC Form’s 10k, 10Q, and 13F to tell a story about Two Sigma Securities, LLC – the formative market making arm of the leading and increasingly legendary $50+ billion quant hedge fund, Two Sigma Investments, LP.

Let’s start with the reporting of long stock, ETF and option positions for the 16 quarters beginning 12/31/2014, where position count is slowly ramped up in this operation until a catalyst seems to change the growth trajectory in Q4 2017 (see below):

The idea that a significant catalytic event occurs in the evolution of this formative market making operation in Q4 2017 is further emphasized when considering the recent dramatic growth of the notional long market value of this portfolio from 829 positions with notional value of $525 million in Q2 2017 to 2,606 positions with notional value of $20.1 billion a year later in Q2 2017 (see below):

Now, for those of you – and I suspect there are many, given the current tilt of our audience – that know a bit of the backstory here, these opening charts represent only the most recent chapter in a very long and colorful story involving the electronic brokerage firm, Interactive Brokers Group, and their (former) option market making unit, Timber Hill. Some of you may recall Alphacution’s showcasing of the colossal decline of Timber Hill’s revenue in the Top 10 post, When Market Makers Ate Their Own.

Here’s a refresher for the option market making operation that once boasted a 3-year revenue run rate of ~$1 billion or more (2006-2008) before its near total collapse:

Two Sigma completed its acquisition of Timber Hill on September 29, 2017. The terms of the deal were not disclosed.

When we combine the recent Two Sigma Securities position data with that of the full available history of the Timber Hill position data, the picture takes on a whole new scale – and the story behind the decline in Timber Hill’s revenue, after peaking in 2008, takes on quite a bit more texture (see below):

And, the explosive move in notional market value of the underlying trading operation, is actually more like an engine moving out of idle into first or second gear. At ~$20 billion notional, Two Sigma is only halfway to the ~$40 billion notional value that this operation was running at in Q3 2011 as Timber Hill (see below):

Of course, a lot has changed in the past decade. The liquidity has moved, the markets are composed of different products, and the players have changed. Some players are gone. Some of those who remain are much stronger.

As Alphacution develops its analysis of those players – and the evolving landscape in which they are operating – the contextual value of the intelligence for each of the players in and around that analysis grows. Already, I believe we are shedding more light on the inner-workings of the most highly automated (and mythological) segment of the trading and asset management world than has ever been attempted before.

Sure, there is an appeal to these stories purely based on a glimpse of the heretofore unseen. Yes, that’s incredible cool – even for someone who was there and in it. But, while increasingly vivid tales of the unseen and gawking at the engines of billions in wealth creation may tickle your curiosity and grab your attention, I can assure you that that aspect of this work is not the true value here. It’s merely the bait…

Speaking of bait, let’s return to Mies van der Rohe and whatever you think may be in those details: For students of the game, the 13F dataset we are assembling (on public and private trading firms) is like buried treasure – particularly when combined with our one-of-a-kind modeling library of technology spending patterns, technical leverage and other operational analytics related to the global financial arena.

Certainly, skeptics say that it’s tempting to analyze 13F reports, however, because they only expose the notional long side of a US listed portfolio, they offer limited value. But, of course, these skeptics are likely to be the very same folks who have never heard of Form X-17A-5…

Essentially, this additional dataset is the balance sheet of broker dealers – and in that balance sheet is the market value of the long and short sides of the very same portfolios that are on display in the 13F data. It is here that we would be able to tease out additional portfolio factors, like dollar neutrality, leverage, and perhaps even some details about portfolio deltas…

For now, here’s a sample of the next level of detail: The relationship between the market and notional values of the long side of Timber Hill’s book for the 40 quarters beginning Q4 2008 and ending Q3 2018:

With this one, we have opened another huge can of delicious worms. The absolute and relative intelligence potential from the development of these data sources is difficult to characterize in words. As stories, it is almost as if there are now so many good ones to tell and so little time to assemble and tell them. Perhaps, a great problem to have.

Let’s wrap with this: Placing an option market making operation at the center of a suite of nested, active management strategies is the state-of-the-art, cutting edge, and best practice. I believe Citadel is operating at the forefront of this concept, and Two Sigma is attempting to emulate that operating model with the addition of Timber Hill. In parallel, and though some of this research is still formative, those market making operations who are stuck in the linear world (without non-linear options capabilities) are currently competing at a disadvantage.

Alphacution can now quantify in greater detail how Timber Hill / Interactive Brokers took their eyes off the prize by not investing properly in technology to compete effectively. Of course, its likely they didn’t possess the vision to compete effectively in the first place. All the technology in the world can be ineffective in the hands of the wrong people. In the hands of Two Sigma, perhaps a new story can be appended to this long and colorful legacy…

As to where the details shared here fall on the spectrum of devilishness, I’ll leave that to you to decide…



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By | 2019-02-12T15:35:18+00:00 January 16th, 2019|Alphacution Feed|

About the Author:

Paul Rowady is the Director of Research for Alphacution Research Conservatory, the first digitally-oriented research and strategic advisory platform uniquely focused on modeling and benchmarking the impacts of technology on global financial markets and the businesses of trading, asset management and banking. He is a 30-year veteran of the proprietary, quantitative and derivatives trading arenas with specific expertise in strategy research, risk management, and operational development. Contact: feedback@alphacution.com; Follow: @alphacution.