“Study the science of art. Study the art of science. Develop your senses — especially learn how to see. Realize that everything connects to everything else.” — Leonardo Da Vinci (~1500)
It has been a little while – since here – that we updated our analysis on the market making and high-speed trading strategy end of the playing field. And, during that time it came to our attention that our friends at Flow Traders N.V. (FT) had begun to feel a little left out of the fun. After all, it seemed we had inadvertently given that impression by showcasing our thoughts on Virtu’s progress and outlook as if it were the only remaining stand-alone public market making firm – now that the KCG acquisition had closed. (For those of you who are just joining us, you might refresh the thread on prior work around this topic, most notably, here…)
Personally, I don’t think Virtu will mind sharing a bit of the spotlight. With the Panthers near the basement of the NHL’s Atlantic division, there are bigger things to worry about. Although, they are getting the last laugh with my beloved Red Wings trailing the Panthers.
Anyway, as a brief formal introduction, FT is the only other stand-alone and public market making firm in the world today, based in Amsterdam, with a global footprint and specializing in ETPs – or exchange-traded products. Also, according to their website, it seems a significant perk of this shop is the latitude to access your Twitch account to stream and play Fortnite and other video games at your discretion, which should be a huge talent magnet…
In all seriousness, thanks guys for the squeaky wheel treatment, as this latest round of model updates – where we juxtapose net trading income and related analytics for the last 18 quarters ending Q2-2018 for Virtu, FT, KCG, and the CBOE Volatility Index (VIX) – was quite illuminating, as you will see with what follows. However, before we dive into the specific charts, I want to pause briefly to hammer a reminder on the context first:
Why is this piece of the story so important?
Because, besides continuing to be a rare bit of transparency into a very secretive, mythological and high-tech segment of the trading ecosystem (that we should not expect to last forever), it also defines the highest levels of workflow automation and process efficiency for the broader asset management ecosystem – and, perhaps, all of global financial services. In short, there is direct observational value here as well as a contextual value for insights about everything else in the neighborhood. Now, that may sound boring to some, but this particular variant of naughty talk is about to go mainstream.
With the increasing dominance of quantitative methods and workflow automation over the asset management world and their stakeholders – as we started to showcase here – tracking the pace of innovation, adoption and dominance around these techniques will be critical for the navigation of business transformation – whether you are already in bed with those techniques yet or not.
So, while it can be illuminating to focus from time to time on the micro-views, it’s important to know that Alphacution is building its platform so that all the micros fit together like Legos to make a comprehensive macro-view, like a map of the proverbial landscape. Think “fractals” if you are still stuck ruminating about naughty talk.
With that, please meditate on the illustration below without further comment, for now – except to say that 1) Virtu and FT are members of the Structural Alpha Zone, along with the not-intended-to-be-a-complete list of others named there, 2) this group is also only a small and concentrated component of a much broader asset management continuum, and 3) the reader should focus on the shapes – in all of the following charts – more than the numbers. (For more on this, refer back to the recent post The Privatization of Alpha and download an executive summary to the research behind this picture here: What Does Citadel* Spend on Technology?)
Now, back to setting the opening thread: For this post, we are looking specifically at strategy similarities among the public market making firms, if any. In a follow-up post, we can go back to our other wheelhouse and add a comparison of technology spending patterns to the analysis. Note also that while FT is focused primarily on ETPs, Virtu is much more highly diversified across products, asset classes and regions. According to their 2017 10-K filing, Virtu “provides competitive bids and offers in over 25,000 securities and other financial instruments, at over 235 venues, in 36 countries worldwide.”
Still, for the first and second quarters of 2018, Virtu averaged 87.8% of its market making revenue in the US and 69.0% from Americas equities. Moreover, this level of revenue concentration becomes more fascinating when one considers that, according to BlackRock, ~80% of US equity volume is concentrated in the top 500 names.
With that scaffolding as a backdrop, we decided to start this exploration with a simple comparison of quarterly net trading income (NTI) using the total available sample of 18 quarters starting Q1-2014 and ending Q2-2018 for these two companies. As you will see, despite its simplicity, it still packs a wallop. (See Chart 2, below.)
Clearly, this picture has a few key highlights: First, it shows early dramatic success of the KCG acquisition by Virtu; and second, the profound impact the spike in volatility in January 2018 had on performance (which will be illustrated shortly).
But, for the love of Pete, how is it possible that these two firms are generating performance that is so similar?! I mean, isn’t it common knowledge that every player who is successfully harvesting alpha and generating double-digit Sharpe Ratios doing so by employing their own unique brand of special sauce?
With a correlation of 0.91 (which indicates a very strong linear relationship), these two track records differ mainly in offset. The “bumps” are similar and the trajectories – as represented by the best-fit trendlines – are similarly positive, as well. However, when we normalize for scale – using NTI per employee – to demonstrate, among other attributes, the variance in “technical leverage” or gross productivity of each business, the picture shifts a bit.
In the illustration below (Chart 3), we present a comparison of quarterly NTI per employee for Virtu and FT. Unlike the prior chart, this version still shows similar volatility in the track records (yielding a moderate correlation of 0.48), but the trajectories are noticeably different. This is primarily due to the ongoing decline in the profitability of US equity-centric market making coupled with Virtu’s acquisition of KCG and the heavier burden of higher headcount brought along with an execution services operation – the legacy Knight Capital. Here, one could argue that the Virtu trajectory of late is a slight illusion because it has expanded its business beyond market making to include one that generates lower gross “revenue per employee,” (or RPE) over the past 4 quarters. A fair, but minor, criticism of this particular interpretation.
So, let’s try something else; a different perspective: What if we assembled Virtu and KCG as if they were one company as of Q1-2014 and then tracked the NTI of that fictional entity up to the point of the actual combination? With this version, the picture changes again – but with less illusion.
In the chart below (Chart 4), the pro forma Virtu (Q1-2014 to Q3-2017) plus the actual Virtu (Q4-2017 to Q2-2018) series illustrates a prevailing intuition about the recent competitive evolution within market making. It’s very competitive, especially when coupled with the impacts of market structure fragmentation, fee and spread pressures, and the post-global financial crisis (GFC) volatility environment, primarily for US equities. Also, remember that Citadel Securities – a private company with no regulatory obligation to disclose financial information – has a big slice of market share here, too – among a few others.
In this prior case, the most notable observation is how we now have empirical data from 3 market making operations – each with their own algorithms, diversifications and mythologies – responding in similar fashion to underlying volatility.
As we did with the first NTI chart, the next step then is to normalize for scale with NTI per employee. So, in the chart below we have done just that to demonstrate that 1) given the independent struggles of KCG and the stand-alone version of Virtu since peaking in Q3-2015, the combination produced a recent resurgence in NTI and gross productivity (given the swift rationalization of redundant technology, market data feeds and personnel) as we predicted here and here. And, 2) without making any assumptions about the rationalization of headcount for pro-forma Virtu, from this perspective, that fictional entity and FT look roughly like the same company – albeit with different futures. (See Chart 5, below.)
Another illusion? Admittedly, yes. Pro-forma Virtu would never have carried nearly the level of headcount represented by simply adding the headcount of KCG – culturally, a much “heavier” operation – to that of its own lean team. However, this “blind alley” exercise does cause us to think more deeply about how these firms are put together, how different companies executing similar strategies with different diversifications that are tweaked to capture volatility differently might still produce results with moderate to high correlation. It’s fascinating…
In the final illustration, we append the VIX to the prior chart – along with some extra visual helpers – to emphasize how volatility spikes cause performance spikes across each of these players. Consider that, although it is far beyond the scope of this already long post, the performance spikes tend to occur when realized volatility exceeds implied volatility for the period in question. After a long period of historically low volatility in late 2017, the vol spike of January 2018 produced this exact pattern – and the dramatic performance spike for both Virtu and FT for Q1-2018. (See Chart 6, below).
Though we have some other illustrations in the works to demonstrate how shares traded and dollar value traded impact performance, the clear story here is and remains about market volatility. Without a better method to predict volatility (no matter how depressed or chaotic it becomes) – and actually tilt towards offensive volatility positioning as opposed to the prevailing defensive posture – players like Virtu and FT (and the others in this group) will still face the significant headwinds of competitive and market pressures; a challenge that can only be overcome today with greater success in diversification and/or combinations of the few kindred spirits who remain in this neck of the woods.
As for better volatility prediction, perhaps that patent I earned in the original incarnation of Alphacution will come in handy one day. But, of course, that is definitely a story for another day…
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