How trading firms stole a march on big banks

In Manhattan, Goldman Sachs and Jane Street are separated by a street, a century, and a 160 per cent average pay gap.

Goldman and its rival investment banks were once the titans of trading. Now it is Jane Street that paid an average of over $900,000 per employee last year to Goldman’s $340,000, according to FT calculations.

The upstart, founded at the turn of the millennium, is among a handful of highly secretive trading firms — also including Citadel Securities, Susquehanna International Group, XTX Markets and DRW — to have capitalised on the electronification of financial markets to seize market share from less nimble and more heavily regulated banking stalwarts, and reshaped Wall Street’s trading landscape in the process.

“The banks just didn’t appreciate how electronic markets and the efficiency of these firms would ultimately make them the dominant force in trading,” said Rob Creamer, president of Chicago-based firm Geneva Trading.

“Banks made big money quoting trades on the phone and didn’t care to prioritise a low-margin business like electronic market making — it was hardly going to pay for the new headquarters in Manhattan.”

Independent trading firms have long been the biggest players in the US stock market, using algorithms to match buyers and sellers of equities and options at mind-boggling speeds.

But they are now emerging as major actors in almost every market and region around the world, even those long thought immune from the pressures of high-speed electronic trading such as fixed income trading.

Data showing the share of trading in various corners of the market is patchy. The numbers that are available point to enormous growth.

Citadel Securities handles $455bn in trades every day, including almost a quarter of all US stock trading.

Jane Street says it now accounts for more than 2 per cent of all trading in over 20 countries. Last year, it traded $6.3tn worth of exchange traded funds and options with a notional value of $32tn.

First-half trading revenues totalled $8.4bn at Jane Street and just under $5bn at Citadel Securities, according to people familiar with the matter, both up about 80 per cent on a year earlier.

The best that the trading divisions at the five biggest investment banks could manage was 11 per cent, at Goldman.

Meanwhile the net value of the trading firms’ assets — so-called members’ equity — has soared, up 12-fold at Citadel Securities and sixfold at Susquehanna since 2008, according to data from Alphacution Research.

The trading firms argue that their technological innovation has made trading cheaper, fairer and more transparent.

“Our commitment to innovation and our continuous engagement with regulators to make markets more efficient have saved countless tens of billions of dollars for market participants around the world,” said Stephen Berger, global head of regulatory policy at Citadel Securities.

Jane Street declined to comment for this article.

But the rise of trading firms armed with better technology than the traditional investment banks poses new and complex regulatory challenges.

“This is an incredibly opaque, sprawling sector of the financial industry,” said Dennis Kelleher, head of financial reform advocacy group Better Markets.

“If we had a better understanding of what Citadel did, or these other big trading firms . . . you could have an informed discussion about what the regulation tailored to those risks would be. But we just don’t know.”

Investment banks have long been at a disadvantage in the trading tech arms race.

Many of the upstart firms were founded around the turn of the millennium, as the raucous trading pits in Chicago, New York and London were beginning to lose influence and computer trading was ascendant.

“I loved my spot in the pit, the whole set-up and the headsets . . . but you know, [I thought] truly this could be a lot more efficient,” said Don Wilson, founder of DRW.

Financial markets got a big push towards electronification from the 2007 rule known as the Regulation National Market System, or Reg NMS, designed to level the playing field for stock trading and requiring trades to be routed to whichever exchange offered the best price.

This helped give rise to the earliest iteration of the modern market makers, the high-frequency traders that could make pennies in profits from vast numbers of transactions in a business memorialised in Michael Lewis’s bestseller Flash Boys.

The ground shifted again when regulators in 2010 heavily restricted banks’ proprietary trading — making bets with their own money — under Dodd-Frank’s Volcker rule.

While they could still be market makers, compliance considerations and capital requirements meant they could no longer trade as freely. Instead, banks evolved to focus on fewer, larger trades for big clients such as initial public offerings or debt issuances.

“Prior to Dodd-Frank we had the advantage that we could be a risk taker and a liquidity provider,” said Gary Cohn, Goldman president from 2006 until he joined the Trump administration in 2017.

“We could provide liquidity and hold it. Once Dodd-Frank came in, we became movers not storers.”

Some trading firms realised they could steal a march on the banks.

“The fact that the regulators did not want as much risk to reside in [more highly] regulated entities was pretty obviously a big opportunity,” said Wilson.

Relying on legions of PhDs and engineers to develop sophisticated trading algorithms, the firms have changed the once-brash culture of trading. Staff are handsomely rewarded.

As the regulatory requirements weighed on banks, proprietary trading firms invested enormous sums on technology to out-trade each other and shave microseconds off execution times.

“How much would we have to invest to replicate their set-up before we even break even?” said one senior trading executive at a large US bank. “It could be three to five years of investment in an environment that is still evolving.”

Industry insiders say banks also had a casual attitude towards non-bank rivals and were comfortable ceding ground, seeing little value in a low-engagement, low-margin business that did not require much interaction with clients.

“They got stuck in and thought their old-school model was going to live forever,” said one former Citadel Securities employee.

Today, banks and non-bank trading firms operate in a complex ecosystem where they are simultaneously clients, competitors and counterparties, a dynamic that at times muddies the waters of who banks are competing against for business.

“Because these guys didn’t fit in that clean box” of traditional competitors, “I think they got overlooked a little bit”, said one former senior equities trader at a large US bank. “In the last 18 months it’s undeniably glaring that they are formidable and more competition than client.”

Over the past 20 years, non-bank traders have captured the vast majority of trading flows across US equities. And they have greater ambitions.

They are already expanding into bonds and loans, markets that can be more opaque and far broader and so have been slower to develop electronic trading.

Parts of banks’ trading businesses — for example providing foreign exchange and liquidity services to large corporate clients — remain entrenched.

Investment banks such as Goldman, Morgan Stanley and JPMorgan are still the go-to firms for more complex or exotic trades that hedge funds might need but are not yet done electronically.

But even in foreign exchange, where banks have been able to rely on corporate clients that are less fussy about price, there are threats lurking from non-bank rivals such as XTX.

Executives at Wall Street banks argue that their best defence is continuing to offer products that trading firms do not, such as extending financing to hedge funds through prime brokerage. Banks also control the calendar for new issues of securities via stock offerings and debt deals.

The new masters of trading are seen by some as better stewards of the market than the banks that came before them. As privately owned firms, any losses are keenly felt by founders and employees, leading to a culture of caution.

“There is definitely a trend where more trading opportunities are open to non-bank financial institutions than has been the case in the past, due to our ability to effectively manage risk,” said Michiel Knoers, chief trading officer at Dutch market maker IMC.

But as the trading firms get bigger, so does their importance to the rest of the financial system.

The 2010 “flash crash”, where tens of billions were momentarily wiped off US equities, alerted regulators to the risks of high-frequency electronic trading.

Two years later Knight Capital Group inadvertently purchased billions of dollars in stocks and suffered a trading loss of almost $500mn in an episode later nicknamed the “Knightmare”.

In October 2014 a violent “flash rally” in US Treasuries underscored how these kinds of events were rippling out from the stock market.

While calls for greater scrutiny of the trading firms have grown louder, critics say relatively little has been done to tackle the issue.

“Regulators need to look at the top 15 players in trading volume, and should be agnostic if it’s a bank or a hedge fund or proprietary trading group, because there is inherent risk when somebody has too big of a market share,” said the head of a proprietary trading firm.

“If they go down, they could take liquidity and cause stress in the market.”

According to Cohn, the firms have grown so large that there will only be one cohort big enough to rescue them in a crisis.

“If one of these large non-bank market makers got into a huge financial problem, the only entity that could bail them out would be one of the major banks,” he said. “They’re that big.”

Non-bank traders say that since they do not take deposits, they would not receive a government rescue and argue that most of the biggest market incidents over the past few years had nothing to do with them.

“Principal trading firms have operated in so many different market conditions without incident,” said Geneva Trading’s Creamer, who also chairs the FIA Principal Traders Group which represents the sector.

“The financial crisis was caused by highly regulated banks, not principal trading firms.”

For banks, brokers and other Wall Street players, there is no question the new trading giants are here to stay.

“We’ve already crossed the Rubicon,” said one former trader at a global bank. “The only question is how far we’ll go.”

Additional reporting by Nicholas Megaw and Eric Platt