Flow Traders - Europe's top ETF market maker - has a unique & honestly insane way of managing their business. I'll explain with a metaphor - ALLIGATORS! A thread:pic.twitter.com/GuoYVaganL
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Imagine you make a market for gators. When people want to buy or sell these reptiles, they come to you. You make money by selling gators at a slightly higher price than what you buy them for, collecting the difference. You make MILLIONS supporting the booming gator market.
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Gator market making is great, but it also has a downside - to make a market you have to keep gators ready to trade at all times. You have to hold inventory of a dangerous wild animal. Gators are unpredictable. And they bite. Hard.
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You can buy protective armor to defend yourself, but this armor is expensive. You don't want to buy full body armor if you don't have to. Profit margins are slim, & optimizing for the most amount of safety with the least amount of armor will help save a ton of money.
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There are two ways to figure out this safety to profit relationship. One is w/probabilities - you can list all the potential ways & places a gator can bite you, model the most likely of these, & buy armor to protect against those outcomes.
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OR, you can approach it more precisely. You can study everything there is to know about the gator - its jaw size, hunger level, muscle strength, even mood & personality. You can know so much about your inventory that you can predict EXACTLY when & where that gator will bite.
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Okay, time to explain the metaphor: Obviously, Flow Traders is the market maker. Market hedges are the expensive armor. ETFs are the gator. Re-read the above thread with these roles in mind.
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Market making is about managing risky & unpredictable inventory. Many MMs hegdge to protect themselves, but hedging against every outcome is too expensive. Most MMs use stochastic models to hedge efficiently - they list a range of outcomes & hedge against the most likely ones.
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Flow Traders is not most MMs. They hedge using deterministic modeling - they model ONE possible outcome and hedge against that outcome. They predict EXACTLY when the gator will bite.
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This way of market making has its advantages, mainly via cheaper, more efficient hedges. But the downside is stark - if their model or research is even slightly off, they protected against the wrong outcome & can lose big. How can a business survive this way?
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Using deterministic modeling, Flow boasts a near spotless market making record. At one point in 2017 they had made it 34 straight months without a single losing day. They made nearly $1 billion in 2020 trading the global ETF markets with impressive efficacy:pic.twitter.com/LLOQVazbZg
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Deterministic modeling reminds me of a great
@TrevMcKendrick post on the science of magic tricks. What looks like magic is really just a glamorous recital of extremely hard work. Flow's precise predictive model isn't magic - it's tedious iteration. https://jacobian.org/2021/apr/7/embrace-the-grind/ …pic.twitter.com/y6ivetBLPS
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The way Flow Traders makes markets isn't the only unique & insane part of their story. I'll be doing a much deeper dive into Flow's origins, business & future as a public company in an upcoming post. Sign up below if interested:https://frontmonth.substack.com/
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