Jane Street, Citadel Securities, Virtue Financial.

These aren't necessarily household names that these high frequency trading firms dominate financial markets.

Companies like these control up to half of equity trading volumes in the US, and their revenues are surging.

In the second quarter alone, Jane Street made over ten billion dollars in net trading revenue, beating out all of Wall Street's biggest banks, including JP Morgan and Goldman Sachs.

But it's also raised some questions.

Earlier this year, Indian regulator SABBY accused Jane Street of market manipulation, something the company has denied.

So how do these electronic market makers get an edge and make so much profit?

How much of a threat do they pose to traditional Wall Street banks?

And can they replicate their success in Asia.

You're listening to Asia Centric from Bloomberg Intelligence.

I'm John Lee in Hong Kong and.

I'm Kajudmitrivelso in Hong Kong.

Today we're covering the sacred world of electronic market makers with Larry tab head of market structured Research at Bloomberg Intelligence based in the US.

Larry, Welcome to the show.

Glad to be here, Katya, John.

Well, Larry, maybe we could start just, you know, kind of back to basics.

What are electronic market makers?

Is it the same as high frequency traders?

How do they work?

And wire people?

Kind of raising eyebrows.

You know, Kacha, that's a great question.

There are a lot of subtle differences, but by and large, these are companies.

You know, there aren't humans making decisions.

Mostly they're machines making decisions, and they're making decisions by analyzing a tremendous amount of data from the various exchanges and trading venues and ascertaining is it time to buyer?

Is a time to sell?

Now?

The high frequency traders, and you know, the ones that are priced a little bit more nefariously, generally take more liquidity than they provide.

And what that means is that when they see a price that's mispriced, they're going to jump on it, and they're going to be faster to the market than you or me or anybody looking at market data and reacting with a keyboard.

The market makers, which tend to be thought of a little bit more positively, they're a little bit more on the opposite side.

They're providing liquidity.

They're the guys, you know, creating the price that you see on the screen.

Their goal is to outcompete other people who are providing prices and try to trade without their price being stale and getting picked off by someone on the other side.

You know, this is not one versus the other.

A lot of times it's combinations of both, because anybody who provides liquidity eventually is going to take liquidity.

Anybody takes liquidity is going to provide liquidity, So it's just a matter of degrees.

As well as, to a certain extent, a lot of quote unquote market makers are registered with exchanges because they get special pricing for providing quotes and providing bids and offers as long as the market is open.

Lart, you made an interesting point.

You're saying that these are computer programs or algorithms.

Were they traditionally done by humans in the past.

This was an area that was traditionally dominated by Wall Street, Right.

These are the guys that you saw, you know, jumping up and down and screaming in pits historically, and actually a lot of them come out of the CME and traditional futures exchanges, you know, like trading places where they're trying to buy and sell large, concentrated or whatever they were trading back when the dan Ackroyd days and Eddie Murphy days.

But yeah, these positions were mostly done by humans with paper tickets, gathering around centralized posts on exchanges, buying and selling.

A lot of that has been automated to a certain extent.

A lot of these strategies.

You know, they're not the same, and they're absolutely not the same, but they do similar functions that they used to do with at exchanges.

So how are they able to trade so quickly?

You mentioned that it's usually a computer, so I'm guessing this is like an algorithm that's set up.

The market makers have different types of strategies, okay, and each of the different market makers, given their backgrounds, have different strategies, so it's not like they're role of running off the same cueues.

You know.

The simplest type of strategy is a provide and take strategy where they buy one thing and they sell it either at a better price or in a different location at a better price, or they buy something and sell something.

You know, there's a share of IBM they buy, they turn around and sell it.

Then you get into more sophisticated strategies where you're trading an underlying stock and you're hedging it or you're training it against an ETF or a future or an option, and so you're looking at you know, the price of IBM maybe against the tech basket, or you're looking at it against the S and P five hundred or a future or an option based on the S and P five hundred, or the QQQ at you know, Nasdaq Tech basket, and then you get into the next derivative of that is an ETF.

And that's kind of where Jane Street.

That was Jeane Street's main business, making markets and ETFs, so they could better understand less liquid actually more bonds than stocks, but they do a big job in stocks, and they can take liquidity from individual investors selling bonds and then turn those bonds into ETFs and turn that liquidity over and then you start getting into even more complicated things like I'm going to do parish trades, or you know, I believe one share of IBM is worth one of HP and one of Apple, and so you wind up with one stock to another stock.

And so there are all these different types of strategies as well as different locations.

So less so in Asia, but more or so in the States.

In Europe, the equity marketplace is very fragmented.

We have sixteen equity exchanges plus another thirty two or so dark pools.

So if you.

Can understand which exchanges lead versus which exchange is lag and where liquidity may possibly be sitting in dark pools, you can execute within microseconds at one venue, turned around and sell it off in another venue.

And sorry, what's a dark pool?

Just for listeners?

I mean you can't say dark pool to a reporter and not have me ask.

No, that's fine.

In the US they're called alternative trading systems.

In Europe they're called MtFs.

In Japan they're called pts's.

But by and large it's a non exchange marketplace.

Many of them don't display quotes, so you're used to seeing the Hong Kong Exchange have a bit or an offer on a stock, and you see the quotes because you see them, they're in effect lit up.

A dark pool still has bids and offers for stocks, but they're not displayed, so you actually have to go to them and say, hey, look, I want to trade synpore telephone.

Does anybody want to buy or sell Singapore telephone in this alternative trading system, and they may say yes, they have a buyer or seller that may want to trade at the bid or the offer or the midpoint or somewhere in between, or they may say no, we don't and they turn around and send your order back to you one filled, in which case you have to go to some other place and look for in These high frequency traders or market makers are connected to all of these venues at very very high speeds.

Now when we're talking about high speeds, we're not talking about seconds.

We're not even talking about milliseconds or thousands of a second.

We're talking millions of a second and faster, so very very very quick.

You know, they aggregate all of the market data from all these different vings news put them into a unified what we call the montage, basically a bigger order book, and so they know if they get a bid for this asset or that asset, they know that they can turn it around or sell it in another venue, and they can do it super quick.

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Larry.

What's the relationship between say, these retail brokers like Robinhood, they don't charge any commission rates and these electronic market makers.

Oh man, now you're getting deeper into the weeds in the States.

Less so in Europe because Europe doesn't favor this.

But in the States they have something called payment for orterflow.

And what payment for order flow is that the retail broker gets paid.

So robin Hood gets paid by Jane Street or Virtue or Citadel a fraction of a cent to send their order to one of these market makers and they execute it in the US.

As long as they execute at work better than the best price that's displayed in the market, everything's fine.

So in the States they have these arrangements where Robinhood will send their order flow to usually a half dozen of these guys, maybe three or four, and they get paid for that order flow, they generally get zero point one the zero point two cents per share.

Generally it's around eleven to twelve cents per hundred shares, and that's the payment for order flow they get.

And because of that, and because Citadel or Jane st referred to, gets the first look at this trade, they're able to price it better than they would price a trade done on an exchange or trading venue.

So by and large, the retail investor gets a better price and the market maker shares a bit of that profit with the retail broker.

Just talking about robin Hood and this concept that the retail investor would end up getting a better price, there's this idea that high frequency trading is crowding out or you know, the retail investor would always be on the losing end because by the time you think about a trade, make the trade on a platform like Robinhood, these algorithms have already you know, it's already happened, the trade has already been made by another company.

So yeah, what would you say to that.

I think that's a little idealistic.

First of all, by the time the Robinhood investor sees that data, Citadels of the world have traded a thousand times, So Citadel is working on a you know, as I said, a microsecond to a sub micro second basis.

And most retail investors, especially ones that they're trading on a handheld device, hey, they're not trading anywhere near the kind of frequency that Citadel or chained for Eat, Virtue or xtx or any of these guys trade aut So they're really completely different markets.

Now, if you're saying that you've got somebody with a super powerful computer that's sitting crunching all these numbers, then you have a little bit better argument that Citadel is picking their pockets.

But for retail investors getting better than the best bid, best offer, it's pretty hard to argue with it.

So they're in very different games.

The individual investors time frame is not seconds or a sub seconds at best.

They're you know, a couple of minutes, hours hopefully, you know, they're looking at years or more than that.

I've always been a fan of saying generally that most retail traders, you know, that's not a wealth creation business.

It's mostly a wealth destruction business.

Most individuals don't have the time or patients to really look at it, or analyze the market or really, you know, you really have to be special to make money this day in a day out.

They're better off with much buying good companies and holding them.

Larry, we talked earlier of the competitive landscape between these market makers and you know the sell side or you know traditional Wall Street investment banks.

You talked about how they have It sounds like they have superior technology.

Is that the reason why they sort of started dominating the market making space and displaced started displacing Cell sign Absolutely?

Is there any other reasons?

Well, it's not just the technology, it's the ability to use it and the agility of their infrastructure.

And what that means is if you think about somebody ely JP Morgan, or Bank of America or HSBC, you know, any any large bank that you would know that as a market making armor or capital markets arm.

First of all, we're no longer in a world where these are investment banks versus commercial banks or retail banks.

These are large diversified organizations.

So when the head of trading says, I need to go buy a new connectivity line between here in Chicago, or between New York and Singapore, or New York and London, or Singapore and Tokyo or whatever.

The head of the bank has to say, Okay, well they have to justify that expense.

You know, should I give the money to the guy who just wants to buy a faster communications line that's going to buy me three milliseconds maybe?

Or do I really want to buy new ATMs for the company, or do I want to enhance my credit card business, or do I want to put that to make more loans.

So right off the bat, you know, in these banks there's a capital allocation process that takes time.

It's not like you know, someone with.

In the trading arm a Bank of American can just go buy a million dollars worth of servers and have them delivered in a week or even a month.

This process can take six months to a year just to deploy a single server.

And so these trading firms, on the other hand, they allocate capital very quickly, and they know that these investments make or break their businesses, so they tend to be much more agile and invest in this technology much faster than what the traditional bank would do.

If you think about the technology investment and jp work, and I think they said there were five to ten billion dollars a year on tech.

That completely towards any of these guys, all of these guys combined, but they're allocating it over such wide you know your raise.

They're not paying their stabs the kind of money you know, consider an l and those guys are paying guys coming out of school almost a half a million dollars a year with no work exp sperience.

I wish Bloomber paid that kind of salary.

This is an assign.

During my last business trip from Singapore to Hong Kong, when I landed at Hong Kong Airport and I was walking through the airport gates, I literally saw a hotel chauffeur have a sign and it said Jane Street Intern.

I was like, and I was like, well, these interns have hotel chauffeurs.

I went straight to the train by the.

Way, right right, I go, and I got a London I'm gone to he Throw Express and I don't have a Bloomberg show for picking me up.

But it's crazy that they're paying these people.

And these people are really talented, and that's why there's a bidding war for them.

So all through the value chain as well as the regulatory side, you know, before the crisis, Morgan, Stanley, Goldman, Zachs, Merrill, Lynch, these guys were regulated as non bank broker dealers and they didn't have to deal with the regulatory burden of being a bit.

After the crisis, they all became banks.

They were kind of forced to become banks.

That comes with a much larger regulatory burden.

And actually, if you look at some of the Dodd Frank stuff and a lot of the Basil three stuff, the regulators didn't want them to take trading risks.

And so you think that these guys get boxed out of the business.

Not really so, James Street, Citadel revert to a lot of these guys prime with the big banks.

That's where they get their credit from.

So now a Bank of America and we're Stanley taking the trading risks.

They're taking the risks on the back end, on the lending custody, the banking relationship, from holding all the securities in cash that is being used to do a lot of this trading.

So they've gone from the front of the line, you know, in terms of trading, to kind of the back of the line where they're making a lot of their money, you know, lending and doing securities lending.

So would it be a simplification to say that on one end, like these electronic market makers HFTs competitors to Wall Street banks on the trading side, absolutely, but they're also customers on the prime side as well as you know, the commission revenue.

Big customers.

Not necessarily the commission side.

It's more the financing side.

It's more on the back end.

It's more you know, they're they're clearing banks.

Since we're talking about that, I wonder what could go wrong in that situation.

You know the regulatory risk, of course, but when you're borrowing so much from banks and you're using it to make these trades, I mean, what are some of the issues that regulators where folks like Elizabeth Warren might be particularly worried about.

Let's not get into my senator, She's worried about everything.

So everybody's saying, oh, all these high frequency traders, bad, bad, bad, bad bad.

All these high frequency market makers are putting these wonderful broker dealers out of business.

On the other hand, we have not seen a marketmaker collapse.

If you go back fifteen twenty years, every year or two you'd see a big Bank, Bearings Bank, Sumi Tomo Trading, and Copper.

Nick Eaton, he was Bearings, Lahman Brothers best done well.

Lehman was a little different.

But you know, with human trading, things are done over the phone, and you write tickets and those tickets have to be processed and the deals are done by phone.

So John Arkati, I'm talking with you.

I buy a bunch of stock, or I buy a bunch of bonds from you.

Guys, we negotiate a price.

You say we're done.

I say we're done.

I'm supposed to write a ticket and have that process.

What if that ticket sits in my drawer because all of a sudden the price has gone away from me.

You know this trade.

My back office doesn't know this trade.

You try to send me securities and get payment.

My back office says, we don't know this trade.

And then the next thing is I double down because I'm right, Because I'm a huge trader, I can never be wrong.

So I do a trade instead of with contient, I do it with a John's company.

And I don't put that trip ticket because that looks like it's going south, and I don't put that in my system.

And all of a sudden.

These positions can get rather large to the tune of what used to be human.

You know, billions of dollars of trading losses.

You never see that at these places, especially since night blew up, because they had four risk systems.

Most of these systems are done electronically, they're automatically processed.

They go through a central risk book.

The central risk manager looks at the positions constantly and says, hey, Larry, you know you're overexposed.

I'm going to go sell out these positions.

So think about trading strategies.

If I'm a market maker, my job is to buy at the bid and sell at the offer.

I'm working on a tiny spread, especially if the markets that I'm working in are moving in you know, milliseconds in microseconds.

I am very very finely balanced on that knife edge.

Okay, So if I want to stay fairly risk neutral, whatever I buy, I need to get rid of her hedge.

Whatever I sell, I need to acquire or hedge.

And so my position needs to be pretty risk monitored or managed all the time.

And so these guys tend not to take huge positions.

They tend to take lots of small positions.

And that's a certain extent makes them less risky.

I also think about it, so if I had to make a market and the market traded once a day, I got to quote very wide prices, and if I want to do any type of volume, I have to do it in big size.

If the market moves faster, then I have more chance to get in and get out.

And if the market moves even faster, I can make tighter prices and get in and out quicker.

And to a certain extent, if I take too large a position, the market can move against me pretty quickly if the market moves really fast.

So these business models really don't support the taking of very large positions.

That said, some of these entities have hedge funds, and those hedge funds work differently.

They have more capital, they could take longer positions, but the market making side generally doesn't.

They had to get in and get out, or get in and hedge.

Laurie, I wanted to bring this discussion to Asia.

Now there's been a lot of news that you know, some of these marketmakers are expanding into this region.

I think Citadel Securities is hiring aggressively in Asia.

There's also you know, Jane Street Jaane Street's already been here for a while and then made a lot of money.

Now they do have some regulatory risks in India.

Yeah, yeah, like the regulator is accusing them of market manipulation.

And by the way, Jane Street's vehemently denying these allegations.

I think they will find over five hundred million dollars.

But having said that, the regulator said that they made of it as four billion dollars over two years.

I don't know there was some huge number.

Yeah, I don't know whether that's true or not.

Whether they were in a minuteulating the market or not.

I don't know.

In a certain extent, they could have been taking large positions just because the business model generally doesn't support it.

If they're making enough money, risk managers tend to look the opposite way sometimes.

I think we'll have to just see how that plays out.

But from what I understand, the Indian market had very special structures that the derivatives market was much more liquid than the cash market, and so there was a very significant arbitrage between the options market and the cash market.

Now, whether playing one against the other tightens the spread between the derivatives and the cash market, which is what it's supposed to do or whether it was manipulative.

I have no idea.

We'll see how that plays out in court.

But theoretically, if the options market goes one way and I can buy an option at a theoretical cash price of ten and the actual cash prices is eight, I would be buying at eight dollars and selling in the derivatives market at ten all day long and pocketing the two.

That's the business model, and theoretically what should happen is the cash price should go up and the derivatives price should go down.

That's how arbitrage works.

Now what actually happened, I don't know.

Getting onto broader Asia, I think there's some really interesting things going on in ASA.

Generally, the market makers move into markets based on capitalization as well as the economics in the market.

So needs to be enough volume to make it worthwhile, and generally there needs to be the ability to hedge or get out of the position.

Whether that means that the cash market is fragmented like in US equities market, but let's just say in mainland China it's hard to buy and sell on the same day.

That becomes very hard, or if you only have a single market and there's one queue, it becomes very competitive to get in.

So you'll see these guys go into the market based on the size of the market, So how much is traded there's only a single market, or whether there's multiple markets like Japan you know has pts's and based on a derivatives market, whether there's the ability to arbitrage cash versus stocks, or cash versus options, cash versus ETFs, cash versus single stock futures or index based futures.

That's kind of you know, will be how these guys will pick the markets that they.

Enter, and do you think they'll be able to replicate the success that they've had in the US with Asia, Like we already know that Jain Street makes a lot of money in Asia, but for the others as well, that's.

A good question because they have not been as successful in Europe.

They do okay in Europe, but not nearly as well as they do in the US, mostly because there's a lot more trading in the States than there is in Europe.

You know, there's time market's like eight to ten times bigger in the States.

Asia to a certain extent is smaller, but it really it depends on how efficient the markets are.

Who are they trading against, is an institutional market or retail market?

How quickly does the market move, How quickly can they get out and find the other side of the trade.

I think over time all these markets will become like you know, pretty much fully electronic.

Whether it's Jane Street who wins, or Citadel who wins, or a local player who wins.

You know that's going to rue the level ofsistication in the market structure.

Yeah, and letter, before we let you go, we have to ask, like, how do you get a job at one of these places?

Generally they're looking for very mathematically advanced folks.

You either need to code really really well, or you need to have really good quantitative skills.

And that doesn't necessarily mean just math.

You could be a physics major or you know, nuclear scientists or something.

So somebody who can really.

Handle lots of big data and lots of analytics and have a kind of a different way of thinking.

They're generally not looking at.

Finance majors or economics majors, are looking at much more technical type folks.

Okay, great, thanks Larry for joining the show.

Great to be here.

A lot of fun doing this.

You've been listening to Age Eccentric from Bloomberg Intelligence.

I'm John Lee in Hong Kong, and.

I'm katjadme Treva, also in Hong Kong.

You can catch all our episodes on Spotify, Apple Podcasts, or wherever you listen.

And this was produced and edited by Clara Chen.

Thanks so much