Etrade: Retail Flow and Market Making

eTrade has an interesting business where it makes money from commissions as a discount broker but most of its income actually comes from interest income as it owns portfolios of assets some of which it had to sell to a hedge fund called Citadel when the markets came under pressure around 2008. A brokerage like eTrade provides retail flow which is considered desirable to market makers because they tend to make money from it.

Why is that? Are retail investors stupid so taking the other side of their trades is generally profitable after bid ask spreads are given to the market maker meaning there is a price discrepancy to the market maker’s favor depending on whether you are selling or buying? No, it is simply because retail flow tends to be the most desirable flow for a market maker: the retail customer buys something and immediately sells it back minus the commission and the bid ask spread. The retail customer tends to change his mind. Or if not him changing his mind, another retail customer will disagree with him and short the stock for example that he just bought, netting the market maker’s position and giving the market maker commission. In the grand scheme, the market maker is providing liquidity to someone who demands it and asks for very little back but pays in full for the liquidity. The retail customer could ask for investment research for example from the market maker as clients of investment banks get from their broker dealer investment banks. But it is absurd as the commissions in total are so low but merely added together across all people is high. So what is the service that the market maker presumably a high frequency market maker offering? He is providing liquidity to a large number of people so they can buy and sell and aggregate their information into the market. Presumably the market maker is making the market more efficient. Now is he making the market more fair? I don’t think so.

The market maker charges premiums for what it calls toxic flow or informed flow: basically buy orders in a row or sell orders in a row as the price moves in the favor of the orders coming in and against the market maker who must take the other side of the trade until he finds a way to unload his inventory. Informed flow would arguably make the markets more fair as unlike bad drivers for example, informed flow shouldn’t have to pay more on insurance policies because they bring in more information and move the market in the right direction. So we could say market makers especially sophisticated mathematical and computer driven high frequency market makers, drive out informed players in markets and make markets gambling realms for uninformed. They provide liquidity but only to uninformed: they remove liquidity for the informed. Some people will argue that the informed flow is mostly insider information and should be removed anyway to make the market more fair for gamblers who bet on no information but what is publicly available. Why should we make our markets less informed as the premise of efficient markets is that insider information seeps into the markets?

The rapid trading doesn’t punish large orders but punishes smart traders who will see the market move against them as long as the market maker has inventory to make the market move without changes to what he needs to buy and sell to maintain his inventory and his place as a market maker. The market maker will stay solvent longer than you can stay rational. So instead of breaking down why not instead of trying to outsmart the market, try to do real work on fundamentals and bring that information into the markets taking heart in that high frequency market making will just basically blockade your trades by bottling the items you sell him into his inventory or selling you items out of his inventory. So your information doesn’t go into the wider market as he has absorbed all of it and he’s the gambler now with the information while you are asked to go home and check on your bets in the long term.

Suppose you have no patience for this and demand that you be allowed to trade medium term or short term even in the presence of market makers. You can’t model their behavior better than they can model you that’s for sure with all the data they see and statistics. They have high sharpe ratios which means they make money without much volatility and that is because they are dealers. If you must trade against high frequency market makers remember they are dumb as rocks and the way to make money from them is to repeatedly introduce information into the markets and they will gradually just turn into fancy commission charging devices as they will stop trading against you as they will see you as toxic flow charge you extra for it but really you are flying first class and that means the market will react in a way to you that helps you trade and that is flying first class.

Take a scenario I outline here to see if you have trading smarts. Suppose I say it is inevitable Asian Americans and Fox News will get into a confrontation on some unknown political issue. What is a Republican who doesn’t identify as Asian usually but is Asian American to do? If you ignore this you have no trading smarts. If you ignore it and make up a story you have absolutely no trading smarts. If you believe them that they are coming for you and do something about it you have trading smarts. Stop hating on machines. Machines don’t bankrupt traders. People bankrupt traders.

What’s your edge? Analytical edge is not edge. My edge was when I hired you as I’m open source. My other edge is I’m quantitative and articulate. If you want to be qualitative you have to be able to talk your way out of world wars not into them. But I suppose I’ve done my duty and that is to my family as family is what connects to the country, an individual could be anything and identify as anything. I think we will have the Republican Asian be Spawn where he is trained by the Chinese to destroy the United States but he turns against them to protect the United States. How do you get a cat to be beaten by mice ask the Chinese? Doesn’t matter because male tiger deals with it so it doesn’t learn from female tigress and take me out. Can say we learned from warrior princesses like Mulan and the lessons of the fighting with the Mongols. I can choose one friend. Whatever I’ve become I ask the U.K. to please come back as your system isn’t dumb it is just toxic flow and my high frequency antics charge you a premium and discriminate against you. Madness? This is Sparta where Sparta is a place where all they do is hockey fight and Athens is where they were told they were uncompetitive because they didn’t have enough kids. The only reason I’m like this is because I assimilated in Canada watching players play like Wendel Clark heart on sleeve blocking pucks when they just weren’t good enough to win. Go leafs go the maple leaf forever.

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