“And the men who hold high places – should be the ones who start – to mold a new reality – closer to the heart.” – Rush, “Farewell to Kings”
Strap yourself in for this one, as we take a fascinating and detailed walk through some of Alphacution’s recent modeling on one of the long-standing Kings of Wall Street; a story that is on the one hand, not widely known and on the other, not typically spoken of…
It was among the most exciting one-two punches of financial markets deals from the late 1990’s and very early 2000’s; one where Wall Street – much like other financial centers across Europe had done in prior years – had reached out, once again, to LaSalle Street for their unique prowess in derivatives trading. (Alphacution detailed the roster of leading players who were part of this wave of acquisitions in a Feed post focused on Susquehanna International Group – SIG.)
In this case, the mighty Goldman Sachs had reached out to acquire Blair Hull’s eponymous proprietary options market making and quant trading firm, Hull Trading Company (Hull) in July 1999 for $531 million – and then, just over a year later, acquired the New York-based securities clearing operation, Spear, Leeds & Kellogg (SLK) for $6.65 billion in September 2000 – thereby reshuffling the increasingly competitive ranks of players closest to sources of listed order flows.
What follows here is the long aftermath of those acquisitions – along with that of the pre-existing Goldman, Sachs & Co. (GSCO) broker-dealer trading operations – to the present day, as symbolized by the significant cache of regulatory data reported by the combined firms since Q3 1999:
We start this tale with the annotated exhibit below wherein Alphacution first presents the 13F position counts by legal entity for the acquisitions in question, Hull and SLK, in isolation over the 30 quarters beginning Q3 1999 and ending Q4 2006. Here, we note that a vast majority of total positions for these new additions can be attributed to the options market making component of Hull; a fact that is common for option market makers (but rare, in general), particularly when reporting in disaggregated fashion, as they are in this case.
Furthermore, we see here that by Q4 2003, GSCO has integrated Hull and SLK into a single unit, SLK/Hull Derivatives, LLC, (at least) for reporting purposes. And, by late 2006, GSCO – presumably with most of the operational kinks worked out – begins to press on the gas pedal of scaling with position counts exceeding that of previous highs established in the post-dot.com bubble period, as they move north of 10,000 (individual) stock and option positions.
This scaling acceleration continues until the eve of the global financial crisis (GFC) when GSCO reports combined positions of 52,044 for Q1 2008 – the most that Alphacution has ever witnessed in a single 13F report. In the exhibit below, Alphacution presents this unprecedented trajectory – in combination with the 13F position counts by legal entity from the prior exhibit – with that of the ongoing GSCO.
Here, we note that the all-time high in positions for Goldman’s broker-dealer operations is not only unusual due to disaggregated option position reporting by the former Hull operation (since the rules only require aggregated option position reporting on the long call and long put sides per underlying security), but we also believe that there may be an un-amended error remaining in this report that makes it seem as if there’s almost exactly two times the positions in the Q1 2008 report as that of the Q4 2007 report.
Now, we haven’t drilled down into the weeds of responsibility for these potential errors yet – although we will get there eventually – but this does get to our recent flagging of potential errors – and occasional error fixes – and outright missing reports with many firms like Jump Trading, SIG, Wolverine Trading, and others. So far, it seems that it doesn’t matter how big or how small or even how simple the operations of the trading firm may be. A full spectrum of trading firms who are presumably supposed to bear the full weight of 13F disclosure requirements have incomplete and/or erroneous filing archives while at the same time have also gone to seemingly great pains to file amended reports over some of the smallest and most benign oversights, like a single missing position or a missed stock split. What’s the purpose of these regulations again? And, who is monitoring this data, if anyone, but a few analysts like us? It’s a strange puzzle, and we will eventually figure it out…
Fortunately, the portfolio value data contained in these same reports automatically normalizes for disaggregated positions. By the associative property of mathematics that we all learned long ago, a sum is a sum whether it is a sum of the aggregates or a sum of the individual pieces. So, in the exhibit below, Alphacution presents the 13F gross notional (long) portfolio value by entity for the entire Goldman Sachs Group – including emphasis on the broker-dealer, GSCO, and the new additions, Hull and SLK – for the 80 quarters beginning Q3 1999 and ending Q2 2019.
Since it is here that we see the trajectory of the entire US listed component of the asset management and trading operations of the parent, Goldman Sachs Group, Inc. – including Goldman Sachs Asset Management (GSAM) and other Goldman entities – we begin to appreciate the wide-lens macro perspective and long-term geometry of, arguably, the most powerful investment banking house in the US and beyond over the past 20 years. This macro-to-micro perspective is a central feature of the Alphacution brand for its emphasis on establishing empirical and contextual value around some of the most powerful and mythological players in the global markets ecosystem.
And, it is here in this long-term portfolio value perspective above that we not only see the impacts of the addition of SLK/Hull in the 2006-2007 period and the GFC from the 2008-2009 period, but we also can see a notable 16.9% decline in gross notional portfolio value for the Goldman Sachs group of entities over the past seven quarters, beginning from a Q4 2017 peak of $418 billion to the Q2 2019 value of $347 billion – a change of nearly $71 billion.
What’s fascinating here is the decline in the same metric for GSCO. That decline in value is $91 billion for the same seven most recent quarters – and the primary explanation for how this can be tied to a decline in options market making, which brings us to the central thrust of this post:
Now, of course, this revelation is not particularly new or novel, especially for those who watch this space closely. In November 2017, GSCO had announced that it was basically withdrawing from parts of the US options market on the basis of “high costs, sluggish volumes and low volatility” – and thereby essentially bidding farewell to what it had started so explosively with Hull Trading. (This is on the back of Goldman’s announcement – in April 2014 – to leave the NYSE floor.)
So, what we want to do from that point is illustrate what a withdrawal like that looks like; present an expanded explanation for why it may have been necessary to make that call in the first place; and then, underscore why this conclusion may be important for other players working in the same, or similar, arena.
We begin this stage of the story by isolating the since-aggregated version of total position counts for GSCO. In the exhibit below, Alphacution presents the 13F total position count for GSCO over the 45-quarter period beginning Q2 2008 and ending Q2 2019. Here, we note the high in positions of 7,077 for Q3 2015 and the subsequent decline thereafter – particularly since the decision to withdraw from part of the US options market – to the latest reading of 4,871 positions.
However, when we further isolate options positions over the same period – in this case, for all Goldman Sachs Group entities; a vast majority of which are represented by GSCO – the decline in position counts appears to be much more precipitous:
And, finally, when we illustrate (long) options positions as a percentage of 13F portfolio value for the full 80-quarter period of this analysis, we see a fascinating perspective on that component of the business. Peaking at 37.8% of total 13F portfolio value in Q3 2011, Goldman Sachs does not fly the flag of surrender in (a part of) the options market until six years later, and only after that component of the book had already declined in (notional) value by nearly 50%, see below.
Now, of course, high costs (due to the ongoing technology arms race and fierce competition for top human capital among the remaining players in this neck of the woods) and (occasionally, historically) low volatility during this post-GFC period did cause sluggish volumes that resulted in a painfully difficult environment for many options market makers. Alphacution has detailed some of this phenomenon specifically in its posts on Timber Hill and “When Market Makers Ate Their Own” – and the (free to download) case study on Spot Trading.
But, even with all that said, there have still been success stories that beg the question for why GSCO and others have retreated from options market making. It turns out there’s more to the story because the explanation for why these exits have been occurring has remained unfinished. In the final exhibit below, Alphacution presents a comparison of option market makers – including GSCO and four others who shall remain unnamed for now – based on the percentage of option value relative to the total 13F notional portfolio value over the period available for each company up to Q2 2019.
Why is all this important?
Here, we are simply trying to demonstrate that the challenges faced by option market makers are not universally distributed. Some players have been able to maintain or increase their option footprint over the same or similar period in which GSCO experienced declines. Now, we fully realize that the books of each of the players in the exhibit above have different compositions which can influence the levels. Some are more of a pure-play in options than others – and, for instance, some have a more diversified bias to ETFs relative to single stocks. However, what we want to showcase here is the geometries – the trajectories – of these lines as being indicative of maintaining a competitive position if not, growing that competitive position.
Bottom line: The part that most firms don’t confess to when they announce an exit from part of a market is the fact that someone else has been eating their lunch and they haven’t been able to figure out how to justify the costs of adequately combating that competitive threat.
The biggest problem with this kind of surrender that we have found so far is this: With some exceptions, an exit from market making in one arena ends up weakening the competitive position of the remaining market making business. Reason being, Alphacution has concluded that, yes, some of the competitive advantages of the successful firms is coming from better technology and more talented people, but that that success is also coming from trading in a wide range of securities that are linked to the underlying securities, like ETFs and options. With the ability to price spreads across product classes (and then managing that book as a series of nested alphas), the leading players are able to bleed those competitors that lack this breadth into submission…
And, the biggest problem with that phenomenon is, with each passing day, these markets become increasingly – and, dangerously – concentrated in the hands of very few who wield technology in ways that cause winner-take-all dynamics to take shape, thus perpetuating the march towards further concentration…
The regulators, therefore, continue to prove not only that they can’t assure the accuracy nor completeness of various disclosure requirements, but that they also can’t even spell Herfindahl (much less, apply it).
So, no matter where you are on our “map” relative to these players, you are still in the path of their impacts. This is another way of saying: If you are searching for a more intelligent strategic response to evolutionary shifts in the competitive landscape, Alphacution is here to help…
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