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If you are a retail stock investor in the US, you have a broker. Your broker is a company — Robinhood or Charles Schwab or E*Trade — that is in the business of having account relationships with retail investors. It advertises to attract your business, it has a nice website and app for you to make trades, it accepts transfers from your bank so you can buy stocks, it sends you account statements and keeps track of your stocks for you.
But what the broker typically does not do is trade stocks for you. If you want to trade stocks, you go to your broker’s app and click the buttons for “buy 100 shares of XYZ,” and the broker’s computer gets the order, and then it ships the order out to someone else, some different company, called a “market maker,”[1] whose job is to get you the stock at the best available price. Sometimes this will involve sending your order on to the New York Stock Exchange, or some other trading venue: The market maker buys 100 shares of XYZ on the exchange at the market price and then hands them over to you. Often, though, the market maker will instead sell you the stock out of its inventory: It is in the business of trading stocks for its own account, so when it gets your order to buy 100 shares of XYZ, it will sell you 100 shares of XYZ as a principal, charging you slightly less than the market price on the exchange.
You do not have a direct account relationship with the market maker, and you might not know who the market maker is on any stock trade that you do, though you can get some general idea from public disclosures. If you are a customer of Robinhood, for instance, your stock orders are probably being executed by Virtu Americas, Citadel Securities, Jane Street Capital, G1 Execution Services or Two Sigma Securities. That’s a pretty typical list; those are some of the biggest market makers for retail stock trades.
Why is there this division of labor? Well, why is there any division of labor? The people who run Robinhood and Charles Schwab are in the business of advertising and providing customer service to retail investors; the people who run Virtu and Citadel Securities are in the business of buying stocks at low prices and selling them at slightly higher prices. The skill sets do not have a ton of overlap. You’ve got Robinhood bopping around building fun apps that make people trade more stocks, but do you want Robinhood risk-managing a big trading book? No, you do not. So Virtu or Citadel Securities or Jane Street comes to Robinhood and says “hey, let us risk-manage the actual trading for you, so you can stick to what you are good at.” And they set up some sort of outsourcing arrangement where your broker sends your orders to a market maker to actually trade.
The economics of these relationships are controversial, and we talk about them from time to time, but for now let’s not worry about that.
I should add that things are slightly different if you are a customer of Merrill Lynch. In that case, your order might get executed by those same guys — Virtu, Citadel Securities, Jane Street, G1 and Two Sigma all trade some Merrill Lynch orders — but it will most likely be executed by another market maker, BofA Securities. Like Merrill Lynch, BofA Securities is a division of Bank of America Corp.: They are technically separate entities, but they have the same owner. Loosely speaking, if your broker is Merrill Lynch, or JPMorgan or Goldman Sachs or Morgan Stanley,[2] your broker probably does trade stocks for you: Your broker is part of a big bank that handles both the customer-service side of the business and the trading side of the business. Historically, the core business of a brokerage included both customer service and trading, but over time people realized that they could be unbundled efficiently.
All of this could in principle be true of institutional investors too. You could imagine a world in which:
- Institutional investors have account relationships with big Wall Street investment banks, who provide them with customer service: account statements, custody, a person they can call when they want to trade.[3]
- But the actual trades are done by some third-party market maker: The institution calls their bank to say “I want to buy 1 million shares of XYZ,” and the person at the bank who takes the call says “I’ll get right on that,” and she types “buy 1 million shares of XYZ” into her system, and the system sends that order to some third-party market maker who actually does the trade.
You don’t see a ton of this at the high end, because if you are an institutional investor you probably care less about the snazziness of your broker’s app and more about the broker’s ability to actually do the trades: You want a bank that is willing to take some risk to quote you the best prices on the stuff you want to trade. And traditionally that was the thing banks were good at. They had lots of money, they employed the best traders and risk managers, of course they would do the actual trades.
Now, less so. Bloomberg’s Katherine Doherty and Sridhar Natarajan report:
Inside Ken Griffin’s Citadel Securities, a new strategy for handling even more of Wall Street’s trading is starting to take shape — with implications for struggling banks and brokerages around the world.
The goal is to offer such firms a white-label trading service: They would deal with customers while Citadel Securities manages the guts of their trading desks, including technology, analytics and order execution.
The nascent plan, described by people with direct knowledge of the matter, could be pitched as a solution for units where profits are getting eroded by stiffer capital rules, competitive pressures to lower fees and the need to make costly upgrades. Firms including Deutsche Bank AG have responded to narrowing margins in stock trading in recent years by shuttering some desks, ceding market share to top players such as JPMorgan Chase & Co. and Goldman Sachs Group Inc.
“Banks and brokers are getting squeezed on both ends, which is where we are seeing customer service deteriorating,” said Jesse Forster, a senior analyst of market structure and technology at Coalition Greenwich. “Investors are not getting their proper trading coverage, and they have been vocal about that.”
Citadel Securities’ move underscores the ambitions afoot inside billionaire Griffin’s massive trading operation, led by Chief Executive Officer Peng Zhao. The firm would likely pitch such partnerships as a way for embattled banks and brokerages to shave costs and offer customers better pricing with superior technology.
It used to be that, if you wanted to trade an exotic derivative or sell a portfolio of high-yield bonds, you could call like eight banks and they would each quote you an aggressive price to win your business. Each of them was willing to take risk to quote you that price: They wanted to be your counterparty on the derivative, or to buy the bonds from you for their own account. Now, banks in general have less capacity to take those risks, and if you call your eight banks some of them will refuse to quote you a price, or will quote you a price that is not very attractive. And you will be aggrieved. “We are seeing customer service deteriorating,” not in the sense that Deutsche Bank doesn’t give its institutional customers a snazzy app that rains confetti when they do a trade — the institutional customers don’t want that! — but in the sense that Deutsche Bank doesn’t give its institutional customers aggressive, or any, quotes on some of the trades that they want to do.
Meanwhile Citadel Securities really is in the business of taking trading risk, and it can hire risk-takers who would formerly have gone to banks. Also the business of taking trading risk (particularly in equities) is much more automated and algorithmic than it used to be, so Citadel Securities’ computers can do the trades that would once have been done by a bank’s humans.
We talk about this theme from time to time around here. The potted history is something like:
- Once, when investors wanted to buy and sell securities, they called up an independent dealer or investment bank, which traded with them for its own account.
- Over time, as regulatory restrictions eased and as the need for scale increased, those dealers increasingly became banks, or rather affiliates of banks: The firms that had the most capacity to take big trading positions were those with access to a bank’s balance sheet.
- After 2008, regulatory restrictions on banks increased, they became less interested in risk-taking, and they became less able to take big trading positions.
- And so now the people who have the most capacity to take big trading positions are not banks. They’re hedge funds, or proprietary trading firms, or alternative asset managers, or whatever.
- Kind of like the dealers in Step 1, except now they have better computers.
The banks still have the relationships, though.
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