When Market Makers Ate Their Own…

Right out of the gate, this story might emit a whiff of last year’s news. Maybe. But, that sense would only last until you realize that this is also a template for improving predictions about future events. And, that kind of predictive power relies upon the bet that more markets and opportunities are becoming winner-take-all in the digital era… (Hint: As the functioning of markets – and other economic opportunities – become more “digital,” a single leader can emerge in that market. This is how we end up with the “FANG’s” – Facebook, Amazon, Netflix and Google. It’s also how US equity markets end up with ~80% lit market-making flows being split between Virtu and Citadel.

Here are some facts to fill in the background: In the three years beginning 2006, the Timber Hill market making unit of Interactive Brokers Group (IB) had an annual revenue run rate of around $1 billion, peaking at over $1.3 billion in 2008. By 2017, Timber Hill’s revenue run rate had declined 94% to $86 million – when it was then sold to Two Sigma.

Now, I am on record for anticipating how the fastest market-makers would end up “eating their own.” Sometimes, this would come out as reaching the “tip of the spear.” In any case, though we could articulate the phenomenon early on, we did not yet have a picture of the impacts.

The chart below is such a picture, and it’s a doozy. It’s certainly among the most colossal declines that you have likely never heard of…

Now, even if we had been monitoring this case more closely in 2008, there still wouldn’t have been enough contextual evidence to see how it all would play out – and when. After all, it looks as if increasing investments in technology were being made to keep up with speed requirements (see chart below).

This illusion may still have persisted even as GETCO, KCG and Virtu came online with their (higher) technology spending disclosures in 2009 and 2011, respectively (see below).

However, by looking at technology costs per employee (“TCO/e”) and comparing across available players, which by 2012 would have included Virtu and KCG, the contextual evidence should have sounded alarm bells at Timber Hill. There wasn’t enough investment in technology being made to indicate that they would be able to compete at speed – and avoid going from hunter to hunted

Thankfully, IB did a masterful job of growing a successful electronic brokerage business (without having to get so deep in the weeds with bleeding-edged technology) – and so, maybe all’s well that ends well (see chart below). Plus, Two Sigma still has its toe in the market making business…

Now, as for using data like this – and pictures like these – as a template to better predict market movements and outcomes, consider this:

  • The availability of data continues to grow…
  • Data that is messy today will be cleaner tomorrow…
  • Tools continue to evolve to better manipulate and automate the process of pattern discovery…
  • All players are leveraging technology to some degree to automate traditional tasks and workflows…
  • And, with greater automation, the possibility for markets and other economic opportunities to display winner-take-all tendencies will increase.
  • Along the way, Alphacution will be working on enhanced predictive capabilities.

Give it some thought. Agree? Disagree?

No worries. We will have much more to say about this, in time…


As always, if you value this work: Like it, share it, comment on it – or discuss amongst your colleagues –  and then send us feedback@alphacution.com.

As our “feedback loop” becomes more vibrant – given input from clients and other members of our network, especially around new questions to be answered – the value of this work will accelerate.

Don’t be shy…

By | 2018-07-17T23:17:56+00:00 July 18th, 2018|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 techno-operational dynamics, and the business impacts of those decisions, in and for the global financial services (FSI) ecosystem. He is a 30-year veteran of the proprietary, quantitative / automated and derivatives trading arenas with specific expertise in strategy research / implementation, risk management, and technology development. Contact: feedback@alphacution.com; Follow: @alphacution.