Are we approaching peak prop trading?
Maybe! Maybe not!
Are the big trading firms that now seem to dominate markets (and whose interns earn more than the Fed chair) about to see a shift in fortunes? That’s the controversial suggestion of Alphacution’s Paul Rowady, a longtime industry analyst.
Rowady last week published an interesting report titled “Approaching Peak Proprietary”, which argued that the two primary drivers of the remarkable run enjoyed by the large trading firms will soon fade away.
The first driver has been expansion into more markets and asset classes. The big trading firms are now all active in almost every major asset class and every region, and have managed to push banks out of several of them. Here’s a killer Alphacution chart that shows the trend in US equity options (zoomable version):
For the curious, the top six banks here are (given alphabetically, rather than in order of size) Bank of America, Barclays, Credit Suisse (RIP), Goldman Sachs, JPMorgan and UBS. Alphacution doesn’t say which firms are included in “top market makers” bucket, but we can probably guess most of them.
Here’s a slightly more obtuse chart showing how dominant the big prop trading firms in particular are in cash equity trading, using positions disclosed in 13F filings as a proxy (zoomable version):
Alphacution’s report doesn’t give out the names, only anonymous ranks, but a different report from last month listed the top five as Jane Street, Susquehanna International Group, Citadel Securities, Hudson River Trading and Jump Trading, in that order.
Obviously, 13F filings only capture a moment in time, and will make some firms that typically carry more financial inventory for longer look bigger than the more pure speed merchants. For example, we’re pretty sure CitSec is still a bigger player in US equities than Jane Street, even though Jane’s disclosed holdings are more than twice as big in dollar terms.
But it’s a decent proxy for who matters, and as you can see, if you’re not top five then you’re almost inconsequential.
Things are a little bit more equal when it comes to US equity options — with the same caveat that open interest is also only a rough guide to overall trading volume shares — but not by much (zoomable version):
Rowady argues that there’s a limit to how much more market share the big prop trading firms can now profitably seize. After all, they’re now mostly competing among themselves, rather than against big old lumbering banks.
Another big driver of prop trading firm profits is that the pie itself has become bigger, even as they have increasingly eaten more of it than banks. For example, option trading volumes have exploded ever since 2020-ish, and periodic bouts of volume-boosting turmoil — eg “Liberation Day” — have been a boon to every trading desk.
But Rowady is sceptical that the growth in the velocity of trading we’ve seen lately can be sustained. The level might stay high, but it cannot grow increasingly frenzied forever.
At the same time, he notes that the prop trading industry itself is giving several oblique hints that it is near the peak:
We know that the most dominant players are near — or, at — strategy capacity for many reasons. When prop firms become active in venture capital, it’s a sign of surplus capital relative to core capacity. Another is when the smaller players consistently die off and new players are not replacing them.
The bottom line therefore is:
We don’t know when the top proprietary trading firms will hit their collective peak. They have definitely been making hay in the recent years of sunshine. Certainly, this is tied to the axes of the global listed cash and derivative product universe (or, at least, the electronically traded universe) and transaction volume. Meanwhile, the headwind to this is the concentration in just a few products — where ~40% of the US equity market has become a leveraged bet on no more than 10 stocks.
We’re inclined to agree, but only up to a point. Making markets/providing liquidity/prop trading in US equity and equity-linked markets are probably now close to zero-sum games — especially at the very fastest speeds — but they’re not quite there yet.
Moreover, the magic happens in arbitrages between all the individual stocks, equity indices and the derivatives and ETFs linked to them all. At a time of Bonk Income ETFs, it seems brave to say that equity markets are so efficient that there’s relatively less money to be made for smart traders.
We’re also sceptical about the idea that there are few inroads left to make in new asset classes and regions. Sure, there’s been lots of expansion by the big firms into areas like Asia and credit markets, but we suspect there is still plenty more potential in these areas, not least fixed income.
So, while the kind of trading revenue growth the likes of Citadel Securities, XTX and Jane Street have put up lately might not be repeated, calling the peak seems very premature.