DeGiro logoThis is shocking news. The discount broker DeGiro has been executing client option orders against their own hedge fund, HiQ. These option trades have been matched inhouse, which means the retail clients effectively have traded over-the-counter options against DeGiro.

And these “OTC” options means you run counterparty risk, the options are only guaranteed by DeGiro instead of a Central Counterparty like Clearnet (used by Euronext).

This internalizing happened without clearly informing clients. Retail investors are unaware they may have done option trades against DeGiro instead of safely cleared by LCH.Clearnet on Euronext. There’s no opt out possibility. This can be devastating for the markets, and implies a lot of extra risk for investors. Finally, this seems to be the “catch” for the low fees at DeGiro.

Solid Evidence, and confirmed

A friend at a market making firm ran into this “inhouse matching” by complete accident. On August 19th he wanted to buy a few Dec’15 20 puts in Ten Cate for his private portfolio. The offer in the screen was 7 cents for 25 contracts. He made a bid for 50 contracts at 7 cent. He was curious if he could get the full 50 lots, so he paid more attention than usual at the execution. You would expect the trade of the 25 lots at 7 cent, and bid on for the remaining 25.

He did receive a full fill, immediately. But nothing traded on the screen. The offer for 25 contracts remained untouched. I have proof of the trade. He bought 50 contracts, but no contract traded on the exchange in this serie all day. After bugging the helpdesk for a few days, they reluctantly revealed the trade was done against a “related company” from DeGiro. They confirmed the trade was done off exchange (screenshot of e-mail, in Dutch). In position overview the put is classified under the Euronext code (“LIF”, from Euronext Liffe), just as any other regular option. In transaction overview nothing is mentioned about inhouse matching.

Clients tricked in OTC trades against DeGiro

This means clients who think trade options with a central counterparty involved – actually have exposure to DeGiro. And DeGiro isn’t exactly a bank with triple A rating. Their sister operation hedge fund HiQ has been taking massive losses.

Basically, when your option order is matched against HiQ you end up with a contract (a “bet”) guaranteed by DeGiro. Eventually it may be possible for retail clients to trade options against other retail clients off-exchange. But what’s the value of such a contract, when it’s guaranteed by a firm with unknown financial safety?

Hedgefund HiQ is on other side of the trades

The latest strategy update from the sinking HiQ says they plan to move to more traditional market making strategy with human traders. They hired ten (10!) junior traders. Ditching earlier quant strategies. This market making strategy, what could it be? After the massive losses, hedge fund HiQ suddenly appeared to be making a bit of steady money again. HiQ is on the other side of retail trades. DeGiro spokesman Gijs Nagel confirmed HiQ can (and did) trade against the retail investors of DeGiro.

From the trade in Ten Cate options, it’s clear the hedge fund HiQ has more possibilities to trade than regular customers. They apparently are able to trade more size than visible in the screen. Other customers can’t hide their size behind an iceberg. Chances are HiQ is joining every market quote in the option market in a stealth mode – nobody in the market can see they did a trade at all. Easy hedging,

Client is counterparty instead of customer

When the broker trades against his clients, this means the clients aren’t really paying customers but counter-parties to trade against. Suddenly you’re broker isn’t your best friend anymore. Doesn’t take much fantasy to imagine conflicts of interest.

For example, you had a margin call and you are forced to buy back a bucketload of certain puts in a stock. And hedgefund HiQ knows about your margin call. When a shark like a hedge fund is in bed with your broker, it’s time to get out.

Don’t set the fox to watch the geese

Easy to think of a dozen other strategies where hedge fund HiQ and broker DeGiro together take advantage of the client orders. Suppose the hypothetical situation the hedge fund has an early view of the incoming retail orders – because they do trade against incoming option orders. What makes them decide to trade against which order? How much time do they get for such a decision? Can they see account details before they trade? (A bid from the guy from Amsterdamtrader? Yes, sell him any size!)

Can’t imagine the AFM (financial watchdog in the Netherlands) would allow such a partnership between a broker and a hedge fund. Above scenario’s are hypothetical, but for sure you don’t want to set the fox to watch the geese.

Devastating for the market

If market makers have little chance to do the good trades on their quotes, making markets is unreasonable. Risk is even more market makers will throw the towel. Who would quote options when you’re only good as a hedge for trades HiQ doesn’t want to keep? Spreads widen in less liquid options classes, and in the end the clients end up paying a lot more for the executions.

To make things worse, these trades matched inhouse against hedgefund HiQ aren’t visible for the rest of the market. When a retail client buys a bag of atm puts in a stock, the hedge fund can hedge their trades easily because nobody has seen the first big trade at all.

DeGiro acting as Central Counter Party

Internalizing of stock orders isn’t such a big deal. Ownership changes hands. On the other hand, options contracts are basically a kind of bets. A bet placed at a reliable exchange with a clearing behind it, is something else than a bet made with a broker / hedge fund with unknown reliability.

Option trades executed on the exchange are guaranteed by the Central Counterparty (CCP). This CCP guarantees all obligations are met. This ensures one doesn’t need to worry the other side of the trade will be good for the money. In this option trade in Ten Cate options, the retail investor has got a long position of 50 lots. The other side has got a short position of 50 in this put.

Positions of DeGiro are held at ABN AMRO. But at ABN AMRO there’s no such long/short position in this Ten Cate option in DeGiro’s account. If DeGiro doesn’t clear this trade somewhere else on a regulated market, it is acting as a Central Counterparty. To act as a CCP you need a license from EMIR (European Market Infrastructure Regulation), which is very hard to obtain. DeGiro won’t have such a license. Not my field of experience, but this certainly looks like a major problem. DeGiro wasn’t able to respond to my questions on CCP.

Is it legal?

There seems to be a legal window of opportunity to start inhouse matching of option orders. Under MIFID a Systematic Internaliser (SI) can match orders of clients and act effectively as market maker. However, this comes with the obligation to be transparent about the price of execution. What was the price before and after the trade?

When MIFID II kicks in in 2017, such internalization of option executions won’t be allowed for SIs anymore. In other words, this window of opportunity will close in 2017. It’s beyond me why DeGiro would grab this temporary easy money and hurt the reputation. Either way, it will currently be illegal to internalize these trades without explicitly informing the clients. To act as a Central Counterparty without a license is probably not allowed either.

Popcorn time for Binck

It wasn’t too long ago when Binck (and to lesser extent, TOM) were taken under fire by DeGiro. The high frequency trader Virtu could frontrun some stock orders from Binck due to a sloppy stock order router. It’s ironic you could say, the tables are turned.

Disclaimer

I had the opportunity to ask a few questions to DeGiro’s spokesman. Unfortunately, he did not react to the second set of questions. The regulation on EMIR, CCP and MIFID isn’t my field of expertise.

There are two conflicts of interest for me, first of all DeGiro has been a reliable advertiser on this website. The other conflict of interest comes to internalizing of option retail flow. As active derivatives trader developments as internalizing option orders could (eventually) hurt  my income.

Reaction Gijs Nagel, DeGiro

Gijs Nagel responded with the statement the options matched inhouse are just as safe as any other option contract at other brokers. The trades aren’t matched at a CCP. Opt out isn’t possible as it’s a part of the regular rules for trading. It has been part of the terms and conditions from the start. He confirms it isn’t possible to see where the option contract has been traded – as the venue of the trade doesn’t matter for clients, in his view. However, if you download the transaction overview with “pdf” – you can see the venue where the trade has been matched. GIMTECH is the code for internalized trades.

Full reaction by DeGiro

Here’s the full reaction by DeGiro on the post above. Wil give a short reaction in a new post, somewhere shortly after the weekend.

Jack
Jack