If GS controls 25% of the daily volume with its program trading, how does it avoid trading with itself? If it does trade with itself, it could move the markets without any cost to itself. Are they explicitly disallowed from trading with itself, or is it allowed? I would think it would be illegal, but who knows with the SEC these days.
You need to understand that there are two categories of program trading . . . one that a broker does in executing trades for a mutual fund or customer which are called "Agency" trades, and the other in which the trades are done as a "Principal". Most of your program trading investment banks are executing orders strictly as an "agent" for their customer. However, their are firms like Deutsche Bank, Morgan Stanley, Goldman, etc. that also "make a market" in the indexes and take the other side of the customer's order. This is a "Principal" trade and is what is done to facilitate an order for a customer. The equity derivatives desk where most of these program trades occur then plays "hot potato" with the other side of the customer order by either immediately unwinding the new position that the desk took on, or they hedge it via futures and options. This has been going on for years. Nothing new. There is also stock-index arbitrage that is done via computers with baskets of stock being bought/sold simultaneously with the S&P futures. This can also be done for customer account, or also for the proprietary account of the investment bank's equity derivative desk. Hope this helps.
That is only forbidden the little guys. They don't little people playing MM. IB doesn't allow placing a sell and a buy order on an option (same security, same expr date, same strike, everthing the same) and then waiting for execution for either or both.
They do trade against their clients. If they are doing a VWAP / TWAP order for a client, their algos may possibly be trading off the order flow. The proprietary algo won't know what the sell desk algo is doing.
Excellent question OP, They actually want to trade with themselves. They play the high frequency ECN game, where they are paid up to 1/3 of a penny per trade. Yes, believe it or not, they are paid to trade. If they buy and sell a stock at the same price, with themselves, they make free money.
Thanks for everyone's responses. I'm a complete newbie so please ignore my naive questions. I guess as opposed to the situation where they are making markets or trading on behalf of their clients, I'm more curious about if an investment bank is trading for their own prop equity desk, where they are trading with the banks own capital. I'm sure there are thousands of human traders employed by each company, and then they have their own set of program trading operations, HFT, etc. Are they allowed to trade between themselves? Let's say two traders in their prop desk traded between themselves, they could easily move the markets depending on how much they were trading, and it's really money going from the left pocket to the right pocket. If you expand this, is it still allowed for them to engage in this type of trading? For example, if the human traders knew their computer program trading would buy a stock if it broke its 20-day high, then they could easily push a stock up to do this and get taken out by their program trading, etc. I have no clue if this is legal or not legal, but I think it seems kind of like bidding on your own auction on e-bay, it doesn't pass the smell test.
And those margins are incredibly small. Being an "SLP" ( sole liquidity provider ) isn't the greatest game in town. With an increase in market participants, spreads have tightened and traditional market making sources of revenue have declined for the sell-side. Even hedge-funds and other buy-side firms are employing algorithmic strategies, such as Citadel. It's a very competitive market place. Don't make the mistake that GS is the only player in town seeking to capture these razor thin margins.
Interesting paper on Algorithmic trading strategies: http://www.algotradingpodcast.com/files/Algorithmic Trading - Executive Summary.pdf