“You don’t lead by pointing and telling people some place to go. You lead by going to that place and making a case.” – Ken Kesey
If you believe – as we do – that everything is connected to everything else, then it stands to reason that all events have potential to be seen as the proverbial canary in the coal mine. Therefore, what we really need to do is notice stuff and connect dots. Here’s a few of our latest observations…
On February 10, 2020, Bloomberg reported “high-frequency firm Allston cuts employees amid low volatility,” and further noted that this move follows XR Trading’s 10% headcount reduction in late 2019. This got us thinking about the tier of smaller to mid-sized proprietary trading firms and if any of the available data (which currently tends to be US equities-centric) provide clues as to the health of those firms – as well as that space in the market ecosystem (where prop firms and market makers reside) that we typically call the structural alpha zone. So, in addition to Allston (founded 2003) and XRT (founded 2008), we took a look at the 13F data for Bluefin Trading, LLC (Bluefin; founded 2001) and Old Mission Capital, LLC (OMC; founded 2009) to see if the act of comparison and the broader sample could shed additional light on this latest news…
In the exhibit, below, Alphacution presents the full 13F reporting history of the aforementioned firms on the basis of gross notional long market values (GNLMV) while including Virtu Financial BD, LLC – Virtu’s longest standing broker-dealer entity – as a reference.
Now, for those that don’t know or haven’t been following closely, Allston closed its equity-linked trading operations (and its SEC-registered broker/dealer) several years ago, in late 2014, to focus exclusively on its fixed income, currency and commodity (FICC) futures trading operations. So, the trail of certain 13F clues drops off in Q3 2014. But, what is disclosed there is some of the strangest reporting we have seen to date – full of gaps and errors – worthy of a deeper dive someday for contextual grins and giggles…
One thing’s for sure, however, a key facet of Allston’s strategy was always to eliminate or, at least, minimize overnight exposures and portfolio construction risks relative to profitability. When market evolution, the technology arms race and competitive threats caused expected profitability to come at the expense of greater portfolio risks, Allston – like many others – folded that part of their overall book. After all, Allston’s was a quintessential high-frequency trading strategy with limited scalability.
By similarity and contrast, it looks like XRT has been able to keep its high-frequency equity-linked exposures below that of the 13F disclosure thresholds from its inception in Q1 2008 all the way up until Q4 2017 when its first 13F report is filed. With exposures increasing from there, one might conclude that, over the past 9-10 quarters, XRT has had to depart further and further from its original strategy (and original risk parameters) to respond to market and competitive challenges while simultaneously attempting to extract desired levels of profitability. Alphacution made the same point recently about Virtu here.
This is all backdrop to make a case for the reality of the evolving market landscape: Competitive threats are no longer local, they’re global. You can’t move to a new fishing hole and expect to remain there unchallenged for long, if at all. The top players are no longer constrained to a specific wheelhouse like futures or options or ETFs. The top players now compete across products, regions, and strategies (including multi-temporal turnover frequencies). In other words, with the industrialization of alpha extraction, firms need greater scale to remain competitive.
Here’s a different perspective on scale and scaling: What does the 13F reporting look like if our sample of smaller prop firms all start at the same time – along with Jane Street Group (Jane Street) and Two Sigma Investments (Two Sigma) as reference? The chart, below, is such a comparison of 13F gross notional long market values:
And, the chart, below, represents total 13F positions for the same sample, along with Jane Street, Two Sigma, and this time adding AQR Capital Management (AQR) as reference:
There was a Golden Age when prop firms only had to worry about competing with other prop firms – and, hedge funds only had to worry about competing with other hedge funds. But, now that certain leading hedge funds have prop trading and market making arms (thus spanning more than one zone of Alphacution’s ecosystem map) – hedge funds, prop firms and market makers are all inadvertently competing with one another…
And so, this is point in the story where we connect some unlikely dots by extending the headcount reductions at Allston, XRT (and others), above, to the story about two consecutive years of headcount reductions that was proposed in the Feed post, “AQR Capital Management: The Ominous Shapes of Strategy.”
Are these canaries connected?
Sure. Maybe we are imagining connections and other patterns in the data that don’t exist. But, when both leaders and challengers are responding to the same framework hypothesis – that everyone is scrambling to harvest finite capacity of alpha – the likelihood that we are misinterpreting the signals seems, at least, lower that it would otherwise be.
Long story short, Alphacution will continue to monitor all players in the context of what happens to the leaders, below:
BTW, the color coding of the prior chart will be unveiled soon, including how XTX ended up on this list.
Until next time…