Malt Liquidity 50

Merton hears a who?

No, Bad

Something a lot of retail doesn’t realize is that small sizing is a big edge in markets. When you do not have to get off a block every time you transact, your price impact is virtually zero (and in fact, you can transact at prices better than your limit orders thanks to price improvement). Remember that old adage, “don’t trade against the size”? Well, there is a benefit to this - much like a bike at the back of a peloton, you can benefit from drifting along the price impact as size legs in to a position. If I am transacting $900 million of a stock, I don’t particularly care whether I buy in at 45.6 or 45.8 - I just want to avoid the stock up multiple %. However, if I’m trading options in a small size, a) a market maker might have inventory they’re sitting on or b) there is a value in filling an option transaction to hedge off some of their price risk. Thus, if I see size impacting the price or accumulating a stock, it might be beneficial to place an order on an option spread at an advantageous fill.

Really think about what a midpoint fill is - when you are being quoted the bid and ask, why would someone fill you at the midpoint? Overwhelmingly, you’re not transacting with someone else trying to sell an option at the midpoint - you’re interacting with a market maker filling the order. As such, there is a reason why the MM might want to come in on the spread, which is in your favor - you do not have to cross fully to the bid or the ask to transact.

The point of this little diatribe is to highlight that there is a lot more edge in small size when the large players are playing rather than when the book is thin and nobody is really transacting. Their transaction cost is your profit. Opportunities for profit are a function of trading volume (which correlates with high volatility, of course), which is why seeking volatility for the sake of it without trading volume is simply massive risk without much upside. Thus, when I see articles and startups like this, I can’t help but think that they’re massively missing the point of trading as a retail trader:

A startup trading platform is seeking approval from the Securities and Exchange Commission to launch the first U.S. stock exchange that would operate around the clock, including on weekends and holidays…

In an interview, Mr. Galinov said there is growing demand for round-the-clock stock trading from individual investors. Not only do such investors often want to buy or sell stocks outside of standard trading hours, but the 24/7 nature of crypto has raised expectations that stocks should work the same way, he said.

“If there is big news over the weekend, you can try to trade, but you really can’t,” the founder and chief executive said.

If you are like me and you monitor trading volumes intraday, you will realize pretty quickly that size doesn’t really trade between 10 EST and 3:30 EST. In between, on non-eventful days, I like to call the price movement “algo drift”, where the spreads on every product are ultra tight, but the size you can get off with minimal price impact is very small. Informed speculators trade when they can minimize their price impact. I don’t see what purpose enabling every market to go to 24 hours would do, other than allowing people to stare at quotes and make more spread-insensitive trades in periods where they objectively have no edge in their sizing. Crypto markets, the bellwether for 24/7 trading, tend to have long periods where there is little volume and the price sort of drifts around as people wait for book depth to come in and people to start trading - the time an asset can trade is an illusion because you want to trade when everyone else is trading. If anything, trading hours should be reduced - at the very least, a lunch break would be nice.

Who exactly are you trading with?

Something I have long been curious about is how exactly Robinhood’s crypto trading actually works. As far as I can tell, they have no wallet support, so does this mean they are just holding on to a bunch of coins and acting as a counterparty/facilitator of crypto trades? How is this not a massive volatility risk to them? Who is their counter-party if they are hedging their price risk through OTC products? Aren’t you supposed to be able to find this information out about publicly traded companies?

Supposedly 41% of their revenue in Q2 came from crypto trading, of which 62% came from DOGE. While speculating on how much internal crossing they are facilitating is pointless, apparently, it is a viable business model, as what looks like a clone in both UI and business strategy seems to have popped up:

Starting Thursday, Public.com will begin gradually launching the offering to most users, who will be able to buy, sell and hold 10 cryptocurrencies, including bitcoin, ether, joke cryptocurrency dogecoin and Cardano’s ada token. New York residents are currently ineligible to trade the digital assets, the company said, because its servicing partner doesn’t have the required license in the state yet…

The company also ended its participation in the widespread but controversial practice of payment for order flow, in which brokerages route customer orders to high-speed trading firms in return for payments.

So not only are they tied to crypto trading volumes maintaining, they also don’t have an alternate revenue stream of payment for order flow. Here’s a quick conspiracy theory:

Let’s say I have a customer base that wants to transact in DOGE but doesn’t want to go through the hassle of setting up a wallet. So, naturally, I offer them the service of trading DOGE on my own platform, but I don’t tell them that their transactions are not hitting the chain if they can be internalized. I charge a network fee, but since the two transacting parties (assuming there is a buyer and a seller) are both on my platform, I can simply change a few numbers in each account with minimal risk, not actually transact externally, and pocket the fees. However, if there is not a match for each transaction, I can essentially become the counterparty and get paid with the transaction fees to take the other side of the trade - in effect, I am getting paid to make a book, rather than operating as a pure broker. This also means I would have to continue accumulating DOGE to match an increasing number of customers using my platform, almost backstopping the DOGE price (as clearly you want to have excess reserves given that you are paying people using VC money to use your platform in the first place). However, as I accumulate more and more DOGE, it also means I can control how I impact the price whenever I want. When I reach a critical mass of a short position (e.g. my customers are all net long and the flow of customers has plateaued), I can liquidate the actual coin myself, impact the price down, and induce my customers into “liquidating” and helping me cover the short position. Not only are you playing the bookie - you can manipulate the odds whenever you want in your favor.

I wonder how much altcoin volume is based around this - it’s basically guaranteed profitability when you trade it from the point of view of Robinhood or Public. Since the business practice of offering crypto trading is so opaque, it’s only logical that some form of this is going on if there is internalization of order flow. This would also mean that you primarily want to offer altcoins, as ETH and BTC are markedly harder to push the price around on. As such, if you want to trade these assets, I’d highly recommend getting a wallet of your own and actually owning what you trade.