I have a friend who has spent most of his career upgrading the plumbing on Wall Street. He is not a pipe wrench plumber, but rather one of the architects of the programmatic trading platforms for some of the 40 providers of liquidity that comprise the US stock market.
He now works for a prestigious principal trading firm where he leads a group that designs and implements both the hardware and software used for proprietary trading. His group will also provide similar infrastructure and software programming for customers of his firm.
I had the great pleasure of interviewing him about Covid-19 risk mitigation and how his world has been changed by retail traders. Let me introduce you to Algo Rim, whose name will be shortened to AR for purposes of this interview.
Rob: AR, thank you for helping us all understand the world of algorithmic systematic or “programmatic” trading. My first question is risk management during the Pandemic. How could you manage risk for your firm and its customers when your group was dispersed and you had to make quick decisions?
AR: Our firm is one of the 20 significant liquidity providers who make up what the consumer calls the stock market. Before Covid-19, our traders managed risk and made critical decisions in a face to face environment. The challenge after our offices shut down was to redesign our risk management systems to manage for the six sigma risk events. We put together a whole new playbook of policies and procedures to eliminate the need for risk management decisions in real time by the trading partners.
Rob: How did it work?
AR: We were quite surprised we were able to manage without any major problems, but we were highly focused on the possible disasters. It was all “need to have, not nice to have.”
Rob: How about March of 2020, when the stock market lost more than 30% of its value in a matter of weeks and then reversed and started rising again?
AR: Our programs worked the way we expected and we survived. We were able to get out early and then return when the order flows reversed.
Rob: This must be attributable to your hardware and software advantage as a programmatic trader? So what is programmatic trading? I don’t think most of us really understand it?
AR: Programmatic trading relies on a high speed, reliable flow of data that can be parsed and analyzed in nanoseconds. The speed is based on an infrastructure we use. The software is based on proprietary trading programs. Trades are executed on the basis of data analytics. “If-then decision making” is faster than a blink of an eye. That is really fast.
The key inputs for risk management and profitability for us are an infrastructure advantage, a data flow advantage, and an almost automatic decision making execution advantage.
Rob: This reminds me of the book by Michael Lewis called “Flashboys”. Is that what your group does?
AR: Yes, but infrastructure is only one part. We have our own high-speed system like the traders in his book and we will also design a system for our customers who are professional investors. We can customize outcomes based on high-speed receipt and analysis of data. You can work with us on just the plumbing, or all aspects of your customized trading solutions. It all happens at warp speed, and it is not unusual to close out trades the same day. Two days can be a long term position for any programmatic trader.
Rob: Are the other market makers using similar tools?
AR: Most retail investors don’t understand the stock market is really 14 separate exchanges and 40 private trading venues and a few single dealers. Together they represent a market ready to provide liquidity to both sides of a stock trade. But most of them are also using the high-speed plumbing and have massive data inputs to help them avoid getting stuck with a losing trade.
When you ask Fidelity to buy or sell 500 IBM and Fidelity goes to one of these venues for liquidity, the market makers are informed bidders and often hold a data advantage. This is especially true of the big providers like Citadel.
Rob: The new normal however, is the perception that the Robinhood “wolfpack” is defeating the high speed programmatic traders, and bringing down hedge funds with short positions by using social media to coordinate short squeeze “attacks”. Is this right?
AR: There is a massive divergence between what you see and what is really going on. The Robinhood story, for example, is more about the stock market’s plumbing, Robinhood sold its GameStop trades to large liquidity providers like Citadel.
Citadel has the same high-speed plumbing as the other markets makers, so it began to develop a highly accurate picture of the retail book of orders. This information advantage enables the market markers to know where and how they want to trade. They have the speed, size and information advantage to make the best bet almost all the time, and they do not have the customer relationship with the retail customer because Robinhood sold the customer trade.
Rob: But is the Robinhood experience a true reemergence of the retail trade?
AR: Yes. We could not believe our statistics, but now 25% of the liquidity in the market is coming from retail. Retail firms will be pressed soon to act like programmatic traders by allowing customized buy and sell programs with trading authorities, but it will still be mostly $2.00 stocks and fractional shares.
The long game is still controlled by a small group that has invested in high-speed infrastructure, has proprietary trading algorithms’ and bottomless capital. Robinhood is like a little league team playing 160 games with the Yankees. Robinhood may win a few games, but the Algo Rims will always have a winning season.
Rob: Final question. Should we have concern about the concentration of market liquidity leading to long term volatility?
AR: The new paradigm is a really small group of market makers with an information, size and speed advantage with absolutely no obligation to provide liquidity. The programmatic and high frequency traders will be the first group to see a reversal and the first group to get liquidity.
The high frequency and programmatic trading firms represent 40-50% of the daily liquidity. When they disappear it could be a long drop before the value buyers step in to reverse the fall.
But the existing circuit breakers work and traders will have time to pause and reflect. Whether the retail crowd can settle markets in freefall is yet to be seen.
Rob: Thank You Algo Rim.