The Best Seat in the House

Vol #196: September 26th, 2024

Sometimes you’ve got to sit orchestra. Front row. 

Down at the Black Cat in Georgetown - there’s always a good seat at the bar. The Tour d’Argent in Paris is the same, every table has a million dollar view over Notre Dame.

But walk into a steakhouse in Chicago or New York, and there are decidedly good and bad tables. Minetta Tavern is fantastic - not so much with your back against the kitchen door. The Windy City has the benefit of a bit more elbow room, but even at the expansive Swift and Sons you could end up at a table for two in Siberia. 

When I walked into RPM Steak earlier this summer with two former DPMs, I knew we were in for a negotiation. Between us there were more than three decades of contiguous floor time. There was no chance we were landing out in the corner. Only a booth with a view would do.

Like the first day of school where your chair in the cafeteria becomes carved in stone, being in the right trading seat matters. 

In a broad sense, that seat might mean the choice of firms. There is an infinite spectrum of methods to capture opportunity.  Even when you agree on a thesis - and that doesn't happen much if our daily volumes are any indication - the way to implement it might vary widely. 

Culture matters too. Is risk a conversation or a hard line liquidation? What’s the right level to double down, or do you double down at all? Some firms push the bleeding edge of compliance, others do whatever they can to avoid the conversation. Paying on a K-1 is a lot different than a W-2. 

But within the sphere of structural alpha players - exchanges, dealers, brokers - there is a finely orchestrated seating chart. Each participant has their place along the riverbanks of flow which dictates how and when they can charge their toll. 

To be clear - this toll is payment for a service. Plugging in the matching engines, pruning the banks, and keeping open the locks so that customers can open and close their contracts. 

Within a trading pit, the melee is not dissimilar from U-5 soccer. At the center of the mass of humans lies the ball. And that is where you want to be. The best seat in the trading pit is the DPM, LMM, or Specialist. ¹

None of this obviates being faster or better. That’s the beauty of competition. Everything gets thrown on the window if you offer a better price. The permanent tension between trading less at a better price vs more at not quite as good price is what pulls markets in and increases their size. Better liquidity. More trading.

The best part is, customers don’t have to worry about any of these rules. Besides the fact that most of their flow gets paid for, auctioned, and price improved, if a customer is sitting on the book, they’re first. The red carpet gets rolled out whether they’re big spenders or not.

Priority market makers don’t get their table for free. The DPMs of the world have an even more stringent obligation than their peers. Specialists need to provide quotes in a higher percentage of series and they need to do so as soon as the underlying market opens. The LMM isn’t there for when things are good and pricing is fierce, they get paid for the short put where they have to backstop liquidity. 

While it seems ridiculous to insist that SPY be less than $0.50 wide, the need does arise. Trading through the pandemic there were numerous instances where no one was willing to stick their neck out and our liquidity benchmarks looked like swiss cheese. 

Part of the reason trading through the Flash Crash was surreal was because of the speed it happened and reverted. Technology had once again outpaced market structure and regulation, so the traditional backstop firms had been gutted by faster shops with fewer obligations. 

So in exchange for bearing this tremendous burden, the lead market makers get some consideration. On most venues if the trade is smaller than five contracts, it can be routed directly to the DPM. 

Part of the game of being a good wholesaling market maker is ensuring that on one of the many exchanges you can route yourself small orders. These morsels are as juicy as they are infrequent. Commercial obligations of providing price improvement to the brokers sending these orders means they can’t leave all that fat on the bone and simply trade at the displayed market. 

In the traditional auction markets on the floor, the DPM was at the center of the crowd and got a priority allocation. No matter how many brokers or market makers were shouting and boxing around, the job of maintaining order and seeing every piece of orderflow belonged to one badge. 

On the books they saw a priority allocation of up to 40%. Practically this ended up being enforced on the ten lots, not as much as the scale grew. But the saber was there for those who chose to rattle it. 

As floor based trading electronified, the various iterations of hybrid trading saw jockeying roles for Specialists. The seating chart is perennially being disrupted. 

I walked onto the AMEX exchange right in the middle of their two year experiment with “ANTE” from 2004-2006.  I knew this system as a computer sitting at the end of our specialist post, where only an experienced clerk could sit. Randomly throughout the day, orders would pop in. The trader had several trillion picoseconds to decide if he wanted it or not. 

There was no NBBO that this was getting routed to; private to the crowd was a bid or offer hanging naked in the wind. In retrospect that sounds like message board conspiracy fodder. But the reality was pits had so much “private” information about orderflow by necessity, and the exchanges were only a few years into cooperating on multi-lists. (As opposed to colluding on independent fiefdoms, as the DOJ found in 2000.) 

Once the exchanges consolidated their order books (but before they each fragmented quadruplets), the definition of a pit, and therefore a seat, started to change. If orders could be sent electronically, do you need to be in the crowd? 

Being in the pit mattered for the big cross, and it still does. But the scale of being able to quote across multiple pits, hopping between the most active products with the switch of a tab was also very lucrative. It also ate into the corners of opportunity firms had previously accumulated - and paid big bucks for in some cases. 

The threat was not only from other registered market makers from far flung places like Philadelphia and the P-Coast, but through the latter part of the 2000s high freak shops posing as customers started boxing everyone out. In 2009 we saw the creation of the pro customer class where if you’re sending more than 390 orders a day - get in line with the other pros. 

Even with that definition in place, the rules got further bent in VIX options. An aggressive interpretation of order allowed “child” orders to reprice without the original order definition changing. I wonder what their compliance officer charges per hour.  Either way, the product was deemed liquid enough that a DPM was no longer necessary. 

The best seat in the house changes. While the SPX and VIX’s of the trading world will always be lucrative, there’s a new UBER or BITO getting listed every day. And even if you don’t have the prime table, the best competitor always wins. 

1. The nuances of all these titles depend on the exchange and is real (wildly interesting to me) minutiae. For the purposes of The Till, I’ll use them interchangeably.