Going Full Rorschach: Estimating the Short Side of Virtu’s* Book

“Everything you need is already inside.” – Bill Bowerman, Track & Field Coach and Nike Co-Founder

Apparently, there is this parallel universe wherein traders and asset managers are able to take each subsequent risk with the benefit of perfect information because there seems to be some implication in our feedback loop that relying on partial or even incomplete fragments of information is not worth the effort.

Tsk tsk…

Now, those of you who have been paying close attention at home already know how much I enjoy flogging my readers with the famed Al Pacino Game of Inches speech from the movie Any Given Sunday to within – uh – an inch of their attention spans, but the point should be fairly clear by now: There are tons of clues lying around in plain sight for those willing to occasionally perform the intellectual equivalent of a dumpster dive for new sources of intelligence…

Maybe 13F reports just have a bad reputation for their poor impersonation of low hanging fruit. Anyway, here’s what we’re going to do to further whet your appetite for what we’re cooking up:

Merge the intelligence found in 13F reports with that of X17A5 reports to demonstrate how it is possible to estimate the short side of the book.

(You’re going to love these. To this day, the Form X17A5 report is so cantankerous and uncooperative that it’s filed as a scanned PDF. The only way to reliably enjoy its fruit is to dig it out by hand…)

One more critical point to consider before we get into a few weeds: We are using one of our favorite models from Virtu Financial to illustrate the following analysis. However, there is a distinguished list of other fascinating and mythological players that will be falling into this same category of analysis along the road ahead. So, without providing the fanfare it may deserve, here’s the list of leading buyside broker-dealers – both market makers and prop shops alike – that Alphacution has placed on deck to explore in detail over the coming months based on their filing of both 13F and X17A5 reports:

Ok, here we go: Among the lineage of legal entities that live under the Virtu umbrella is the aptly-named broker-dealer, Virtu Financial BD, LLC. Digging through the annual balance sheet of this one yields a couple important line items to consider: Securities owned (on the asset side) and Securities sold, but not yet purchased (on the liability side).  Together they yield a solid proxy for the long and short sides of Virtu’s US equity book, at annual, year-end points in time:

Note: These are holdings. This data does not capture any round-turn trading in any product that occurs intraday, which is where most market making profitability resides. However, as a reminder, the fact that there are any holdings at all suggests that the operation has scaled to the point where being flat at the end of the day has become too costly. These holdings represent portfolio scaling beyond available liquidity at required exit costs.

Now, when we net the “long” and “short” sides of this portfolio, we get the following temporal measure of dollar neutrality:

Notice how the range of dollar neutrality seems to decline as the value of the portfolio grows. The question is whether these risk guardrails are intentional or purely serendipitous based on underlying flows. We may never know for sure…

Though we don’t necessarily need it to make an initial estimate of the short side of the book, comparing the notional market value of the long side (13F data) with the actual market value of the long side (X17A5 data) does give us some insights into the application of leverage. The exhibit below implies that no leverage was applied along this time series until 2017 when it appears the leverage gear increases to 2.5. Given that this timing corresponds with the acquisition of KCG, there is some probability that there is some kind of illusion in the data. We will wait to see what the 2018 X17A5 report – due in the coming weeks – discloses…

So, if we apply quarterly-adjusted versions of the annual dollar neutrality measurements from the X17A5 data to what can be observed of the long side in the 13F data, we can arrive at an estimate of the Rorschach-like mirroring of the short side:

Here’s what the absolute value of the estimated short side looks like (for skeptics):

And, here are a few concluding observations and thoughts:

  1. The short side is reliably and consistently smaller than the long side. This is primarily due to the costs and mechanics of maintaining a large short book. We expect this to be true for other large portfolios as we apply this type of analysis to other leading buyside broker-dealers.
  2. Though we see little reason to do so now, there is a yet more detailed level of estimation that could be performed to reverse-engineer portfolio construction parameters – and position level candidates – based on historical and competitive analysis of the existing data.
  3. Based on the illustrations of both the long and the estimated short side of the book above, there doesn’t appear to be a growth trajectory in the value of this portfolio from Q3 2012 to the point of the KCG acquisition in Q3 2018.  One cause of this “flatness” may be the lack in growth of position count, which may further suggest some limitation in the underlying signal generation methodology, see below:

We will stop here for now – and leave you with a refresh of our list of upcoming research topics and targets to contemplate, below.

More on why this target list – and the sell-side and exchange counterparts that go with it – are so important very soon…

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By | 2019-04-03T20:53:55-04:00 February 20th, 2019|Alphacution Feed|

About the Author:

Paul Rowady is the Director of Research for Alphacution Research Conservatory, a 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. Contact: feedback@alphacution.com; Follow: @alphacution.