Euclid could have been a hedge-fund manager.
The Greek mathematician and father of differential geometry defined our understanding of three-dimensional shapes in roughly 280 BC. Thanks to Euclid we know what a cube is and that right angles are all equal.
In 1982, mathematician James Simon started a money-management firm that would seek superior returns not by studying business strategies and financial statements but instead through adhering to mathematical and statistical methods, especially differential geometry. Today, secretive Renaissance Technologies, called RenTech by most, manages $37 billion mainly for its principals. Simons retired in 2009 with an estimated personal fortune of $12.5 billion. Math works.
In 1999, two years after the SEC passed rules on handling trades and set regulations for alternative trading systems that today we call dark pools, Richard Korhammer and his engineering colleagues started a direct-access platform they named Lava Trading. This was a subtle nod to differential geometry and the construction of surfaces. Everything, including equity markets has a surface, and in stocks its the top of the book. But below it, in whats not displayed, is where the action lies.
In 2003, Lava filed a patent on its technique for aggregating market data and placing some trades while hiding others – the top of the book versus the rest of the orders. Differential geometry. The firm became the market-share leader in direct access, a way to describe how investors could skip the stock exchanges to trade with each other.
In 2004, Citigroup spearheaded a dark-pool invasion by big brokers, buying Lava Trading for some $500 million and making it an independent unit. LavaFlow Inc. became known for its market-participant ID (MPID), a four-letter identifier traders use to see whos driving orders. Goldman Sachss primary MPID is GSCO. Morgan Stanleys, MSCO.
Lavas was FLOW, and FLOW was everywhere. Its still big. For the week ended November 10, FINRA ranked LavaFlow sixth among dark pools behind Credit Suisse, UBS, Deutsche Bank, and the star of Michael Lewiss hit market-structure tell-all “Flash Boys,” IEX. Combine FLOW with Citis two other dark pools and Citi ranked third.
But Citi is chilling LavaFlow, hardening the surface and shutting it down. In July, the SEC fined LavaFlow a record $5 million for permitting a smart order router, computer code that makes buy/sell decisions with high-speed data, to use confidential customer information in trading decisions.
The SEC said these orders totaled 400 million shares over three years. Citi dark pools match that much every two weeks so the allegations concerned roughly 1 percent of it, a rounding error.
Pulling out of a market where youre ranked 3rd of 36 seems extreme. But it reflects facts that capital-markets participants should recognize. First, the stock market isnt a market anymore and firms like Citi are demonstrating by actions that they recognize it. A market by definition is aggregated buy/sell interest.
The stock market today is the opposite of that, with disaggregated and hidden interest, intermediated oftentimes by parties with no wish to carry inventory in the products the market supposedly offers. This is not a guess but an observable and statistical fact. High-speed intermediation is routinely eight or 10 times the price-setter of natural interest, yet rarely more than 3 percent of all liquidity.
Number two, rather than admit the rules they made in 1997 birthed dark pools and shattered the stock market, regulators are going to regulate dark pools out of existence, and Citi sees it coming. If you think thats good, remember how we got here to begin with.
Third and perhaps most important, Citi ranks second in another market: Derivatives. Bloomberg reported in September this year that Citi has grown its derivatives business nearly 70 percent since the nadir of the financial crisis and now serves open derivatives contracts worth $62 trillion, second behind market-leader JP Morgan ($68 trillion). Its the largest counterparty for interest-rate swaps, the biggest derivatives segment. In derivatives, Citi IS the aggregator.
It fits what we see in equities. When energy stocks took a breathtaking hit following OPECs decision to maintain production levels recently, the behavioral shift was in hedging. The magnitude of movement in prices says it wasnt driven by ownership but notional value. Notional value can reflect tremendous demand or its utter absence in the space of heartbeats because its not actual ownership. We saw stocks drop 30 percent or more in two days without any meaningful movement in investment behavior.
This is what institutions are doing. It reflects the uncertainty of everything, everywhere. A great deal more money than most realize is putting and taking interest in stocks through derivatives like swaps. That fact is increasingly setting share-prices.
For Citi, the money is in this aggregation, not in equity fragmentation. And so Lava slows, stills, and hardens. Its just differential geometry.
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Tim Quast is president and founder of market-structure analytics firm Modern Networks IR, LLC based in Denver.
