Elephant in the roomDeGiro’s response to the previous post on matching client flow to their own hedgefund was a 3 page long pdf. While ignoring the big elephant in the room, they had some valid points too. And some nonsense.

Counterparty risk

Valid points first. When your broker collapses, your position in derivatives isn’t secured nor guaranteed. Whether the transactions are executed on exchange or matched inhouse, this doesn’t really matter. When your broker goes down, you’re screwed with derivative positions. This applies to any broker, not only DeGiro.

The Central Counter Party (CCP) is safeguarding firms higher in the hierarchy, such as ABN Amro Clearing. Therefore the CCP protects you against “risk through the chain” impacting your broker. So, DeGiro is just as safe as any other broker? Not so fast. DeGiro is closely tied to their hedge fund. If the hedge fund collapses with a bang, so will DeGiro.

The elephant in the room

The main point remains client orders are sent to DeGiro’s hedge fund. DeGiro argues hedge fund HiQ is just a regular client. And clients match with clients – so retail customers match with HiQ. Anyone believing HiQ is a regular client just like any other, is believing in fairy tales (and/or working for the AFM).

In theory, no information is shared between DeGiro and HiQ. While they both share the same office, there should be a Chinese wall between them. That’s hard to believe when you’re sharing an office. Also difficult to keep things secret for the guys from the hedge fund. As Niels Klok, Jasper Anderluh and Gijs Nagel are the board of HiQ Invest. And guess who’s on the board of DeGiro, next to spokesman Gijs Nagel?

The systems of the hedge fund are connected to DeGiro. The broker should keep the details of client flow as secret as they can, especially for hedge funds preying on the orders. But the hedge fund guys are the same people as the broker. “We wouldn’t take advantage of the situation, because that would be illegal“.

It didn’t stop the broker ITG in the US. Make no mistake, I’m sure DeGiro isn’t engaged in anything illegal, but it’s not a convincing argument. Compare it with insider trading. That’s illegal and unethical too. Instead of relying on ethical standards, companies prefer to keep the inside information, well, secret.

Security lending

Some securities are difficult to borrow. If you want to build up a short position in Imtech, Air France or Gemalto – you’ll be paying a premium short stock fee. HiQ can borrow shares for nothing from DeGiro. They can post a collateral, but they are on the same boat as DeGiro anyway. If HiQ is a bit short of cash, DeGiro will finance.

Problem arises when things go awry. Imagine they are on the wrong side of an extreme event. HiQ goes bankrupt, as goes DeGiro. It’s not a bank, the losses have to be covered from somewhere. The retail stock portfolios will need to pay. In a sense, all retail investors combined are a safety cushion for the hedge fund. If this happens, the official reaction will be : it’s in the terms and conditions. You signed for it.

Internalization in turbo’s and sprinters

This is also strange. Clients can be inhouse matched in structured products like sprinters and turbo’s. These products are trademark of other financial institutions (like ING Bank, Commerzbank). They make markets on the exchange, invest in marketing. When there’s no open interest in these products on exchange, and the knock out barrier is hit : who decides on the settlement level when the only open interest is inhouse matched in the books of DeGiro?

Devastating for the market

Maybe the blogger means that he, as a market maker, wants to profit from the spread that our clients want to pay instead of letting DeGiro give this advantage to its own clients? It is really the case that due to our efficiencies we remove part of the easy money for the HFT and market making community. Instead of keeping this to our selves, we give it back in low fees. Our clients seem to love it.

When many option trades are executed off exchange, the quality of the market will deteriorate. Depth of the market will be worse, and spreads will be wider. Liquidity providers in the real market invest heavily in infrastructure and IT. By quoting financial instruments they always run the risk of an even faster competitor hitting them. If there’s no such thing as competing for incoming retail orders, quoting tight spreads makes no sense.

Assume the hypothetical situation all brokers internalize option flow with such join orders. Without any transactions on the exchange, the market makers won’t quote. Price discovery gets problematic. That would be devastating for the market.

There’s no such thing as easy money for HFT and market making. Trying to get the best retail orders may earn a few bucks for HiQ on the back of real market makers and liquidity providers. There’s nothing in it for the retail investors, because the money is taken by HiQ.

If HiQ blows up

HiQ result

Inhouse matching in the option market will happen between clients, according to DeGiro. But in reality it will happen between clients and HiQ. This means the retail orders will end up in the books of HiQ. Of course DeGiro is placed between clients and HiQ, but what happens when HiQ blows up? They will have thousands of option contracts against DeGiro. But when something unexpected happens (Volkswagen ’08, Altana ’07) hedge funds can collapse and the contracts will be worthless.

No matter how agreed AFM is with this setup. When HiQ collapses, DeGiro will be dragged down with it. A hedge fund blowing up isn’t really related to the latest losses in HiQ (see graph). Also the shrinking assets under management (19 million) isn’t a prelude to a collapse. Collapsing hedge funds usually go with a bang.

Your cash held at DeGiro is kept in an umbrella fund, under the HiQ invest holding. Click for large image below. A bit odd, but suppose the watchdogs AFM and DNB will make sure it’s safe.

LPE structure

Risk management

DeGiro will send a margin call if the risk on your short options increase. If you don’t wire extra cash, risk management will buy back options in the market or sell some shares. But who controls the risk management and margin of HiQ? The management of DeGiro is the same as management of HiQ. That’s extra risk, and in the end it’s extra risk for the customers.

HiQ nearly got caught in de VW squeeze in 2008. Clearing bank ABN required them to cut their losses (effectively saving them). The next time the risk management is in their own hands. DeGiro is in charge. If they have a sound risk management policy, and enforce it on HiQ it would make a big change. But who guarantees?

Terms and conditions

DeGiro has always been eager explain their story. Investors are paying too much at rival brokers, DeGiro is offering less luxury with discount prices. Also, DeZiro will be a business model without transaction costs. A lot of press coverage. But not a single word, ever, about internalizing clients flow to their own hedge fund.

If you have nothing to hide, you shouldn’t leave it out in the communication. It’s in the terms and conditions – well, that’s not enough for being called transparent. Ironically, the only reference ever to internalizing client flow to HiQ was this post. Only a modest 10% of the orders are internalized. But with the ten (10!) new rookie market makers hired by DeGiro HiQ Invest that could change.

Join orders

It also explicitly says in terms and conditions the so-called “join” order isn’t possible. But at least HiQ has been using this order. Which means the terms and conditions are now false. But let’s assume they will update the terms, and other investors can use the “join” orders too.

For Join Orders, the party that has the highest number of Join Orders shortly before the opening of the relevant reference market is given priority over other Join Orders for all its Orders on the relevant exchange. If a Join Order is executed, the party that had priority at this location has the possibility for 1 second of placing an Order again, which will again be given priority.

This means if you send more join orders, you get priority everywhere. But you don’t know how many join orders the other client (HiQ) is sending. Suppose you have to tell DeGiro how many orders you want. But HiQ knows what you’re doing, as DeGiro is the same company as HiQ. The same people.

Anyway, on the same page..

Join Orders may lead to partial executions. For each partial execution, the executed part is divided proportionally over all clients taking part in the Join Order. All clients receive the same average price for this execution.

Priority in the queue, or pro rata divided over all clients participating in join orders? I’m lost here.

Banned by 2017

The blogger mentioned MiFiD 2017. As far as we understand it now, there is no rule in this new regulation that will change our current order execution policy.

There’s not much discussion about it. Find a better advisor. With MiFiD 2017 internalizing option flow will be banned. The only venues allowed to execute option trades will be RMs, MTFs, and OTFs – meaning no systematic internalizers (SI). Here’s a good summary if you want to read more about it (I do not).