10 Billion Served: The Unsung Role of an ETF Market Maker

of corners of the et F world except for one. Yeah, we are squeezing in the one thing we haven't talked about just in the nick of time for this whole year. And yeah, but and then we will have I think officially officially covered everything at least once. And this is market making? What is that so market making? You know? I equate market making too sort of the oil, the

oil that keeps the whole machine running. Or to to bring it to a much more broader references mcdonne donolds, market makers are basically providing happy meals all day long. They are just churning out customers. In fact, if you look at the total amount of et F trading over twenty five years since they came out, it's about two hundred trillion dollars worth of trades. The average trade size

is about twenty dollars. That means there's been ten billion at F trades, and that ten billion trades is countered with maybe thirty forty thou sort of issues where there was a problem with the trade. So you compare those two numbers. That's why I think these market makers and how they give everyone a happy meal. Everybody's happy, is why I think ETFs are largely immune from the attacks, the criticism and the worries. Is because the customers come

in get their happy meal. That like, that was fine with me. But the happy meal actually was all about the toy. Well, I don't know. My son loves the nuggets, Yeah, he likes that now that Yeah, and my wife makes them get the apples and she does not eat not so happy. Joining us on this episode any Massa, who's a reporter with the Bloomberg News investing team. She just wrote a story called Raising the Stakes in the latest issue of Bloomberg Markets. That's about one of the most

famous market makers, which we'll get into. And also Chris Hinstead, who's the head of e t F sales at this week on trillions, let's make a market Annie Chris, thanks for joining us and raising the stakes. What's this story about. The story is about a firm called Susquehanna and it's been around in the e t F market making ecosystem

for a really long time. And um, well, the firm was founded in seven so that was before you even had ETFs in the U S. And they were founded as an options trading firm and they're still huge in options, but very early on in the timeline of e t F they got into e t F trading before it was even a thing. Yeah, exactly before it was cool. And they've really survived as an dependent proprietary market maker um closely held, closely held, yep, and very secretive for

for all these years. And they've really become one of the biggest market makers of e t F s in the U S and in the world. And let me just jump in here, Susquehan A lot of people may not have even heard of them. Jane Street is another one you added up, and a good chunk of all the e t F market making, which is you know, matching buyers and sellers and whatnot, happens through companies that are not large investment banks, some investment banks do it,

but I think that's interesting. Did you how did you look into that? Yeah? I wanted to address that in the story because investment banks, especially since the two Crisis, have kind of stepped back from playing some of these key roles in the E T F ecosystem. And since then, um, there's been even more runway for these smaller prop firms to get involved, and and they've stepped in to fill

the void in some way. And when you say what does that mean, Um, they're they're trading with their own capital, right, which is something that banks used to be able to do and came no longer. And that's one of the reasons that they fill this void so well. Exactly. So, there's a certain game that people who work in market making are very good at, and you learned a little bit more about that. What's what's the game? Yes, it is poker, And especially at Susquehanna, this has always been true. Um,

they love Texas Hold Him. They have an annual no limit Texas Hold Him championship basically every year. Their traders are trained in poker. And the idea is that they wanted first of all, the founders all like met in college at Sunny Binghamton, and they all like to play cards together, but they quickly found out that they could

apply some of the same skills to financial markets. It almost sounds like a dream where we're going to go to college, play poker all the time and then say like, okay, how do we take our poker skills and get a job I know, and and found a that will go on to be very successful, you know, make millions and millions of dollars exactly. So, I mean it's it's pretty remarkable and um. And so they've kept this program of training their traders with poker and other kinds of games too.

They even have like they have a gaming blog like on Strategy for everything from like scrabble to you know, any kind of game that you can imagine. So they yeah,

they love gaming there, but especially poker. Why is poker a significant game and how does it relate to E T F S. So the idea is they they see poker as a great game that allows you to kind of practice making decisions in uncertain circumstances, probability based decisions and uncertain circumstances, and that mindset applies to financial markets too, because you know, obviously you don't have control over all the other whims of the market, but you can make

these like probability based decisions in those kind of uncertain circumstances. And Susquehanna particularly is the sort of original firm, and it's kind of been like a farm a farm league for superstars that have gone off and gone to other firms in the in the market making business, right, it's sort of like black Rock is like that. On the issuere side. You go to a lot of e T f firms, issuers, a lot of them are like, yeah, I used to work at black Rock, and Susquehanna is

kind of like that for the market making side. Is that right? Yeah. The way I was thinking about it is it's almost like a diaspora of people who would just have spread out from Susquehanna is their home base. And by the way, people stay there for a long time too typically and they really cut their teeth there and then the people who have left have risen to

the top at other notable market making firms. And and one of the ones that I mentioned in the story is Jane Street, which is now a very I mean a very fierce rival of Susquehanna's was founded by three ex Susquehanna guys and another ex Susquehanna guys sitting right here, those in there are not. My opening question for you, Chris is how good at poker are you? I am not. I am not necessarily a good poker player. How did we get through the system? But I would sit in

that tournament every year. You know, every employee plays at least one hand, and I would certainly try to compete with the with the brightest of the firm and and last as long as I could. But easier said than done. So you started at Susquehanna, right, So I'm myself and and others like me when we came into Susquehanna were brought into the firm because they started to trade more e t f s, which were different than their core

business prior to that, which was options trading. ETFs trade more like a stock but their derivative in nature, and so operators like myself, uh in the equity world would come up and apply some of our equity trading background to this derivatively backed equity like product on the American

Stock Exchange. And we were originally like kind of hired clerks, hired guns in a sense to operate the display book, which not many people know what that is, but it's back when the trading was done on the floor of the Stock Exchange, and like mid nineties, this is mid and late nineties, um is when that sort of started to to really pick up, especially in the late nineties with the listing of the q q Q on the American Stock Exchange in March and after that it was

pretty much hockey stick growth and activity, and we were very lucky. I think a lot of the folks in in in the role that I was in a lot of my peers at Susquehanna and other firms like Spear Leads and Kellogg which was later acquired by Goldman sachs Um, and there's there's several firms from the American Stock Exchange era that did these kind of et F and option

trading market making operations. They all needed operators and our job was very unique and very different, and most of us survived the post stock market, you know, the post stock exchange trading world, and we're able to take what we learned from working with with really bright people at SIG and Spear leads and other places and apply that

in other places. Because the et F industry was growing so fast, you know, as the market structure changed, there was a there was a significant need for people who understood the product and understood the math behind it. And if you could go somewhere and apply that there was there was a job for you. So Eric says, making markets is like serving happy meals. How would you describe it? Um, Well, it depends on it depends on where we're where we're cooking,

I guess, or where we're serving. So, you know, we we always make it a point to differentiate between the most widely held and most widely trafficked in products. So you think s P Y E M, I w M. There's the g l D. These are the most active by notional volume, the most active by trading volume in many cases UM, and the most widely held across the

you know, across the investment universe. Those products. The the third the term market making is not is applicable to those It's not something that a traditional market maker would need to step in and say, on the absence of buyers, I can be a seller, and the absence of sellers, I can be a buyer or something along those. When we flip that and the absence of sellers, I can sell, and in the absence of buyers, I can buy. That's

traditionally what a market maker does. A market maker UH injects liquidity into the market when it's needed and sits on the sideline when it's not needed. When it's not needed as when buyers and sellers meet naturally in the market.

The thing about e t S it's unique is that there's what Eric, there's two thousand, two hundred thirty something ets today in the US, so it's something right around there, and that super liquid widely held or a high volume and widely trafficked to an ETF list is really only like a hundred sometimes two hundred names on any given day. That means there's a better part of two thousand products that don't trade buyer to seller now actually in the market.

In most cases, the further down that list you go, the more like it is that any transaction in the market, a buy or a cell is most likely more likely

than not going to transact with a market maker. Because the odds of the four of us sitting at this table as retail investors trading with one another in e t F ranked number one thousand, whatever product that is is so low that the quote you see on the screen on whatever exchange, or on all the exchanges is probably being provided by a market maker in anticipation of potentially someone buying or selling that product. So let's just

try to visualize this. On any given day, people are putting in orders for s P Y or I VV or h y G, and that order is being matched electronically on the exchange for the most part, and market

makers are not needed for those transactions. They you put it, you can put in a market order, right, just give me the this e t F at the best available price for the top hundred then below that is when you know the spreads are a little wider, meaning the price that someone would it four versus sell it, right, And that's when a market maker might step in and

make a market in those products. Yeah, I mean, I wouldn't necessarily say that the spread widens out, although you can definitely make the argument that the less active a name is and the less um the less the people are using it, that would it would seem to indicate it would be a wider spread, but not always the case.

I think it's it's more it's the increased likelihood that you're not going to be transacting with somebody natural, with somebody who happens to be selling when you're buying or buying. When you call those natural, right, yes, that's when the buyer seller matches and you're you're not involved, and that's

just a natural don't need for us. In the real estate market, imagine if you're in a grocery store and the buyer of a house and the seller of a house just meeting the broker's stand there saying what the hell happened? What percent of the daily trading volume in et F, which is about let's say fifty billion or something, it's even it's I think it's been north of the

October we were seeing a hundred billion dollars. That was volatile times they definitely, but on average, let's say fifty, say what percentage of that is naturals versus market makers? It's it's probably gonna be north um naturals in other words, And and by the way, that does not mean that in that natural all right, that's going to include some high frequency traders, right, because they're not really market making, they're just you know, they're they're trading, they have strategies

and algorithms. Other hedge funds and institutions might use these products as hedges their naturals um even though it might not be part of their investment philosophy, they're using the product in a natural way. For for what we're talking about today, market making is more in the traditional sense, Hey, can I come to you and ask you for a bid or an offer at any time of the day and you'll make one for me. That's the more traditional sense, and yet I would guess it's way under of the

of the volume on any given day. Is is that

at UM. Now there's something that's changed also in the last couple of years, and there's there's new technologies that these trading firms that we all our orders eventually at at Schwab or TV or wherever, might wind up on a trading desk somewhere if it if it meets some metric and that's going to go out into what we call r f Q. You know, Bloomberg has an r f QUE technology that's request for quote, right, and that's just where you go out there requests for quote and

it goes out and finds complete. It surveys all the market makers to get the best price. Right, That's right, and that's well the ones that are enabled, right is it? So it's it's that you know, look, I mean there's there's probably little less than ten market making firms that are in in most of the RFQ wheels. So it's not a wildly competitive market in terms of the numbers, but it is incredibly competitive in terms of the margins um.

The pricing today and ets has never been better in terms of the efficient you know, pricing that people are getting in the secondary market. But when they go out and do this, that's so if they if someone was to transact in a block of an e t F that trades once a week, that's probably going to be a market maker providing liquidity um those volumes because their blocks can can be a little bit higher, and that might be where most of that market maker activity in

terms of notional volume exists. When I talk about that, you know what doesn't go natural natural um is probably in block liquidity. Those margins though, being as thin as they are, brings it back to poker a little bit, because the strategy at sus Quahana, at least it seems is rather than trying to get these big one time payouts, it's just like eke out the pennies and then the pile of pennies happens to actually be worth a lot

of money. Yeah, I mean, I don't want to answer, you know, for what what's it does you know for their strategies. But I can tell you that what's great about e t S and what the world needs to continually be reminded of is these are transparent rappers. These are transparent vehicles. They on a daily basis provide us with what their holdings file, uh is, what what's in their holdings file, and also what's needed for creation and redemption.

So most of the time, the products, the kind of products that are within an et F whether it's whether it's futures, whether it's swap, whether it's equities or bonds, there's price discovery mechanisms for market makers to go and figure out what the ingredients are worth. So Eric talks about making a happy meal. Well, imagine if McDonald's had two thousand different kinds of happy meals. But I work in the kitchen and I have all the ingredients that I need, and so when you order Happy Meal number

sevent thirty two. I simply pull up the recipe the holdings file and I look and I say, well, how much is it gonna cost me to buy these ingredients and put it in the happy meal box and deliver it back to you? So if I look and I get my computer, it's all preloaded. Every night. We have really sharp people that download that stuff. And I put it up sevent whatever and it says, oh, okay, I'm gonna need these thirty different ingredients and it's gonna cost

me five dollars to make this happy meal. Well that's my break even price, right, So I'm probably going to offer you the happy meal and a penny, right. And this is just for example purposes only, but that's that's the mentality behind market making expensive happy Yeah, well that

that toy better be illegal. That one had caviar and saffron, so you know, um, and this is a really I just want to stop here for a second because what you're tapping into is something we've built a lot in the terminal, which is implied liquidity, which is when you talk about the top uh fifteen most traded ETFs account

for half of all volume. Then the other and fifty or whatever are fighting over the rest, and a lot of them get ignored because people are used to stocks where the volume on the screen is all there is. But with an E t F, you can punch up the recipe. In other words, you can use the volume

of the underlying stocks. So example, if we pull up something like the Power Shares S and p high quality E t F, which isn't one of the more popular quality factory t s, I think it might trade shares a day, right, But the imply liquidity says fifty one million shares could be created on the spot because that

recipe is liquid. Is that essentially the key to unlocking the toolbox and using some of these lesser uh, lesser traded products that might be a better fit because people do tend to lean on these ones that came out in the nineties that trade a lot. Yeah, I mean, it's it is it. Just remember if you're a user of E t S, you don't have to worry so

much about having the toolbox or the key. It's it's more important for you to trust that you're broker and the person you're working with for these executions in the investo. You know, high quality uh, index that they have the key in the toolbox. And basically what we're going to be looking at is maybe we're not going to do

a forty million share trade. We'd love to do that, right, but if someone goes in and says, hey, there's forty thousand shares that trade on a daily basis and we want to buy a million years, well, we're looking at as a market maker, as a liquidity providers, we're looking at, can I access the ingredients of that fund without moving the market? Am I? Am I going to be able to reasonably obtain all the ingredients that I need at a reasonable or at least some sort of a confident

price level. Anything outside of that we would call in the old world, we'd call that slippage. I thought I could buy it for twenty five, and when I went to actually buy all the ingredients, the price moved. I actually impacted the market and it came out to five. And I would say to my boss, look, I thought I could buy the ingredients for twenty five. It wind up crossing me five. And he'd say, well, where do you sell the happy meal? And I'd say, one, I

guess what I lost? Right, That's where the betting and gambling kind of mentality will be associated with market making. So market makers generally don't make that mistake. Okay, they're they're actually doing you know, pre trade analytics, and they they have a very good high confidence in and how much they can buy at at what price level, how much they think they're going to move the market given a certain size. Well, you love to talk about, imply liquidity.

We love to talk about if I was to do a million shares of the ETF, it could be ten thousand percent of a day's volume of the e t F itself, but it can be one tenth of one percent of the underlying portfolio. And that's what we want people to remember. If you're a broker and your and your trading partner has the tools and the toolbox to to view that as one tenth of one percent of the underlying liquidity, well then you should expect you know, pricing that's reflective of that. What does it take to

be good at that? Because it strikes me that there are a very few E t F market making firms that that are actually really good. Like one thing that I heard when I was reporting on that story is, you know, the volume of E t F trading and the number of E t F s has has just gone up and up and up, and the number of really strong et F market makers has stayed small. So what does it take to be like a good E t F marketing? I mean there are when you talk about the spies and the w m s and the

q k c is, it's different. It's a different trading strategy, it's a different sort of mentality. Again, you're not expecting to be able to sell k k K and then by the underlying as de one hundred names um at a at a material discount to where you sold the t F. That just doesn't happen. Um it's so efficient those products. But when you the competitive field that we're talking about is what does it take to be competitive

in that investco product? What does it take for someone to be able to compete with five other market makers and provide the best price at ridiculously low margins. So you know, you're talking about fractions of a penny in many cases, depending on the size of the trade, it takes a lot. Technology is a big part of it, and data data within that technology is also a big

part of it. So you've got to have access to the to the information of the E T s and there's two thousand two ts, so it's a lot of information, and you're pulling in every night. You've got to be able to apply market data to all of the underlying instruments. And there's you know, gosh knows how many different equities in the E T F universe, and over five thousand and how many different bonds, probably well over ten thousand.

I mean, there's so much data, and it has to be constantly updated, and it has to be constantly monitored and maintained. And when you get it all right in a perfect world, right, you've got all the data, and you've got all the recipes, and your computers are humming, and everyone's happy, and everything looks great, all the lights are green. It's pretty easy. Actually. You look it up and someone pulls up a ticker and they say, can

I get a price on it? You pull it up and you've got your highly confident pricing that you can you can provide to your clients and they love your pricing and they trade with you. But what happens when one of the data feeds goes down? What happens when there's a corporate action that didn't get picked up by the issue where but did get picked up by the distributor.

And there's a difference in information because with I don't know how many a hundred unique issuers and kashners, how many different custodio banks and distributors, We're getting information from a lot of different unique sources every single day. Normalizing it is a massive task, right, and so it requires investment,

It requires confidence. It requires really really smart people, you know, who know how to code UM so that at any given time, when the light goes from green to red and says, look here, something's amiss, you can get to that very quickly, you know, adjust your formula, adjust whatever input is questionable, and get back to business. There really a light that goes from green to red. I can either confirm light yellow light. I want to ask about s PHQ that's that high quality, doesn't trade a lot,

say an order comes in for this. I've always found I found this kind of fascinating when I learned it. When when it's not a natural and somebody wants s PHQ UM, you cannot find a natural by order or to sell order to buy it, right, So you've got to look at the recipe, you give them the SPHQ

immediately for a certain price. Then what happens, Right, you don't actually have s PHQ yet you have to go take the raw materials the recipe handed into power shares or the a P and then get SPHQ to make yourself. Even walk us through that that process and how long

it takes. So it's important for everyone to realize that you're you're trading counterparties and easy tfs, especially SPHQ, are most likely licensed to create or manufacturer shares when they're needed, and issuers don't like to hear this, but they're also licensed to destroy or redeem okay shares when there's too much supply. The ability to create this is the magic

of the e t F arbitrazed. You do have ecosystem, it's called being an authorized participant um whether you're directly an authorized participant or indirectly through your clearing bank is

it's important. But if you have the ability to manufacture or destroy, create or redeem et F shares when you come in and buy s pH Q from us, and we don't have shares and is no borrow But by the way, most of the two thousand two change e T s. There is no borrow on them, right, So most of the time, if you're buying these and in a material way, a market maker is going to probably

have to create shares to settle that trade. So in s p h Q, you come in, you buy a million shares, and I'm going to turn around by the ingredients of the fund. Now, I'm going to take those ingredients deliver them to power Shares. Power Shares is going to say thank you very much in return for those securities, which they're going to put into the et F Trust, which is their own unique et F trust protected and they're gonna give me back a million e t F shares of s pH Q, which I'm going to deliver

right back to the client. So the round trip is what are the ingredients. I go out and get them, I put them into the happy meal. You give the happy meal to the client. This is happening in second like fractions of the second. I mean the process of doing the trade with the client and buying the annoying portfolio. Yes, it could be a fraction of a second. There may be times where we choose to go out and buy the ingredients of an et F over a longer period

of time. When you look at the high old bond market or investment grade bonds, or maybe some frontier markets, it might take longer to go out and buy the actual underlying securities. You might want to be a little more thoughtful and how you go about getting it. But but essentially, yes, you you trade the e t F and then you get the ingredients and then you do the creative. So because market making is so secretive, it leads me to it leads me to believe that it's

highly lucrative as well. How lucrative actually is it. I don't. I don't think it's secretive. I don't. I anyone can go to an issuer's website. A great thing also about the U S. E t F marketplace is that to be listed on an exchange in the United States with it for an e t F, you need to have a website. You need to have information available for people to go and look. If your website is not available,

you're not in compliance. UM. On the websites, you'll find a holdings file, So anyone can look at the holdings file, figure out what's in it, figure out what the weights are UM or not even figure it out, just download the data and and then figure out what it costs to assemble that portfolio, and and and in turn what's a fair price for the ETF. That is the secret sauce.

That's not so secret, right, It never is the competitive edges, but it's the hisvenience factor, because you could you could basically copy an et F every day and not have to pay the issue with the expense ratio or do the trade and you have to manage it too though, you know, and and look, there's I always like to sit sit down with clients, sit down with users, explain how it works, show them how to do it. They get that moment of clarity, they get that moment, that

eureka moment like I get it. And then they also at the same time realize that's a lot of work. I don't want to do that and what they really wanted can you do? Do you have a system that does that a lot faster and a lot more efficiently. And and the you know, the ten marketing firms, you you know, you allude to where this the ETF industry has grown in the marketing communities has just gotten faster,

not necessarily bigger. That's ultimately the answer. So, so, while the sauce is not so secret, the way that people cook things is a little bit proprietary, right. How it evolved though, Like where you have some market makers, Like if you're just making markets and et fs on exchanges, like, you don't really have to tell anybody anything about what

you're doing or how you're doing it. But if you have clients who are coming directly to you and trying to do E T F trades, like, then you kind of have to open yourself up a little bit more, right, Yeah, I mean we me personally, I've I've sort of migrated from the trading world into more of an educational, client facing world. I love when they ask questions about how and why we price things the way we do. I

love to tell them what we're thinking. I love to tell them how much we think we're going to need to make or how much we're going to have to price things to make it worth our while to do the trade or to get into business. Unfortunately, not a lot of people ask those questions all the time. There are people who come in and just trust you know how to do it, and you get the order and they move on. If you're always giving them good fair pricing,

and you continue to get that business. They may not ask every time how you came up with the price, But I do enjoy when people engage because it gives me, it is me hope that because they're asking questions, they're probably looking at other products. A lot of people will only look at those top fifty, those top hundred products because they're easy to trade, but they don't really add a whole lot of value in terms of an investment mandate. Right.

And so when they when they come up with SPHQ and they come in and they say, hey, can you tell me about this product, I want to get on the phone and I want to spend an hour with him. Say this is what's cool about this product. This is why power Shares loves it, this is why we can make a market in it, and others can probably too. This is what we would consider a fair level. You know for this, you know, transacting within these bands, you can never lose to asking questions and and learning more.

I think it gives you the confidence to take that next step and buy that product you've never heard of, and guess what, you know, you're going to be the cool kid on the block who owns the product no one else does and based on lucrative I will address that a little bit. We've looked into the revenue of the e t F world. We track it. Um issuers make about seven billion a year. That is not much. I mean, that's on the issue side. Active mutual funds make you know, or five times that amount on the

same amount of assets. Market makers make about half of the seven billion. We've calculated about three and a half billion, and that's on an average spread of point, so we're talking razor thin margins. It's actually not that lucrative. Most of the e t F industry has to really live um frugally and be scrappy. It's not like the old Wall Street I find that's why it's so popular, because everybody comes in it feels like they've got a good deal. Okay,

so I have one more question. What's your favorite ticker? What's my favorite ticker? Oh? My goodness, oh man, Well, I gotta say. I mean two eighteen um, I mean, there's a there's a a t F called r VRS reverse and uh I actually I just think it's a really neat thing. There's what's in that It's well there's SMP market spy, and then there's RSP which I loved

for a long long time. I love equal weight uh SMP five hundered I personally, you know, personally from my account, I'm like, I like egle waight better than market cap. Wait and then, um, these folks invented r VRS and it's reverse cap weight and as a triangle, I'm drawing a triangle on a pocket is the lowest waiting? Um yeah, I like the idea. I just and a ticker, and a ticker serves it well. RVRS great. Yeah. I think they used the Juno card, the reverse Uno card to

market the product. It was pretty good. Although they they have beer glasses, but they I told him that the top should be small and it should wide. Now you're gonna get in a ton of trouble with that question, because like that was on the spot. I didn't know it was coming. And and I'm sure they're gonna be psyched. But you know, I'll get one really great phone call from that and it'll be like thanks so much saying that,

And I'm gonna get like, why didn't imagine mine? There's so many there's so many good I want to say I didn't forget about you. Happy anniversary, Happy anniversary, Jelf, Chris, Annie, thanks for joining Central, Thanks for let's in to us on Trillions until next time. You can find us on the Bloomberg terminal, Bloomberg dot com, Apple Podcast, Spotify, and basically anywhere else you want to listen. We'd love to

hear from you. We're on Twitter, I'm at Joel Webber Show, he's at Eric call Tunis, and he's at Antonia b Massa. Trillions is produced by Magnus Hendrickson. Francesca lead is the head of Bloomberg Podcast, but