Over two years ago, and just days after Michael Lewis released Flash Boys focusing attention on the ongoing criminal practice of orderflow frontrunning by such Fed intermediaries as Citadel (and many other now entrenched and recently IPOing names), none other than Citadel's head of "Execution Services" which we supposed is the internal name of the firm's client-facing HFT group, Jamil Nazarali, proclaimed that small investors have never been so fortunate and said, with regard to Michael Lewis' now infamous book Flash Boys, "The most important thing that the market can do is stop... pointing fingers at everyone else."
As we said back then "Citadel, who allegedly provides the NY Fed's VIX trading capabilities, are among the very largest high-frequency traders in the market (and the most levered), so one would surely expect that Citadel would like us all to stop pointing fingers at them. As Bloomberg reports, Nazarali said yesterday during a panel discussion at the Milken Institute Global Conference in Beverly Hills, California, "things are much better today than they were 10 to 15 years ago."
Maybe for Citadel; for investors - who are tired if not disgusted of having their orders constantly frontrun by internalizers and wholesale market-maker venues such as Ken Griffin's Citadel - not so much.
Which is why we were not surprised, though certainly delighted, to see that after years of railing against Citadel's dominant position at the intersection of HFT trading and retail orderflow - recently Citadel was found to be the largest private US trading venue - this morning Reuters reports that Federal authorities are investigating the market-making arms of Citadel LLC and KCG Holdings looking into the possibility that the two giants of electronic trading are giving small investors a poor deal when executing stock transactions on their behalf.
According to Reuters, the DOJ has subpoenaed information from Citadel and KCG related to the firms' execution of stock trades on behalf of clients. Not just Citadel, the DOJ is also looking at a number of high-speed trading firms that pay retail brokerages to sell them their flow of customer orders for stock trades. This segment of the industry is known as wholesale market making.
In the case of Citadel, authorities are examining internal data concerning the firms’ routing of customer stock orders through exchanges and other trading systems, to see whether they are giving customers unfavorable prices on trades in order to capture more profit on the transactions.
In other words, the DOJ is looking into whether Citadel is frontrunning its clients, something we have claimed for years.
As a reminder, Citadel is so big and its own private stock-trading platform is so large that, if it were an official exchange recognized by the Securities and Exchange Commission, it would one of the largest registered exchanges in the United States - bigger than Nasdaq Inc, according to data published last month by the Financial Industry Regulatory Authority. Citadel Execution Services, the firm’s wholesale market-making unit, executes 35 percent of all trades by retail investors in U.S.-listed stocks, according to the firm.
KCG was formed in December 2012 from the merger of New Jersey-based Knight Capital Group and Chicago-based high-frequency-trading firm Getco LLC. Knight was forced into the merger after an August 2012 computer trading glitch led to millions of accidental stock orders flooding the market in less than an hour, leaving the firm with a $468 million loss
The documents subpoenaed from KCG related to the firm’s market making activities from 2009 to 2011, Reuters adds. In 2012, the head of KCG’s electronic trading group, which included its wholesale market making arm, Jamil Nazarali, left the firm to join Citadel. Since then, Citadel’s own wholesale market maker has grown substantially under Nazarali. Nazarali is also the same person two after Flash Boys came out said that "small investors have never been so fortunate." Let us guess: "because bid-ask spreads have fallen", right? Well, first that's wrong. And second, how fortunate has Citadel been to be able to frontrun billions of retail orders and generate billions in risk free profits.
And while we doubt anyone will go to prison, there is a small chance Citadel's egregious frontrunning will at least be minimized for the time being: the inquiry is being driven by Justice Department authorities who previously investigated banks for alleged wrongdoing in the market for residential mortgage-backed securities. Making those cases, which yielded billions of dollars in penalties, required investigators to master some of finance’s most complex markets. The current undertaking presents similar technical challenges.
That said Reuters adds that it isn’t clear what sort of evidence the federal investigators may have compiled in their inquiries. And it is possible that no cases will result from the investigations. A spokesman for KCG declined to comment, as did a Justice Department spokesman. In an August 2015 filing with the SEC, KCG disclosed the existence of a Justice Department probe but provided no details. A spokeswoman for Citadel said she could neither confirm nor deny the firm’s involvement in the investigations, but said Citadel cooperates fully with any requests from enforcement agencies.
“As one of the largest market-makers and providers of liquidity in the U.S., we regularly receive inquiries from and work closely with a number of regulators and others regarding our business and market practices,” said Katie Spring, a spokeswoman for Citadel. “We cooperate fully with such requests, but as a matter of practice, we simply don’t confirm any particular inquiry.”
What happens if the DOJ does find what has been obvious to market participants for years?
If authorities do move ahead, they would be marching forcefully into the debate over high-speed trading. Critics have alleged that firms with the fastest trading technology are using speed to manipulate stock prices, giving investors a raw deal. The industry counters that its technology delivers cheaper and more transparent trades to investors.
It also delivers guaranteed profits to itself, because while on one hand Citadel is a massive market-maker, responsible for the biggest portion of retail flow traffic, on the other it happens to be the most leveraged hedge fund in the world in terms of regulatory to net assets
This means that the fund has massive prop capital at its disposal to take advantage of its knowledge of flow traffic. It also explains why Citadel's "tactical trading" unit has been one of the best performing hedge funds for years even as the rest of the hedge fund industry has fallen behind.
Finally, it's not just the DOJ: Citadel and KCG are among several firms being examined in a separate probe by the New York State Attorney General, Reuters reports. New York authorities are examining firms that buy and sell the flow of trading orders placed by investors, according to a person familiar with that investigation. The authorities are also looking at other practices in the world of high-speed stock trading that may disadvantage retail investors. Citadel and KCG declined to comment on that inquiry.
As noted above, we doubt that anyone will end up in prison, however we are curious if there is any connection between the existence of the probe which has clearly put the firm's frontrunning operations under the microscope, and Citadel's recent underperformance. Actually scratch that: we are dead certain Citadel's poor YTD returns are precisely because the DOJ is making the firm's frontrunning life impossible.
We also wonder hos much it will cost Ken Griffin to sweep this latest scandal under the table.
Finally, we are curious if Citadel will have no choice but to minimize if not abolish outright its retail orderflow frontrunning as a behind the scenes settlement with the DOJ. If so, the market just may regain some semblance of normalcy. Now if only there was some way to eliminate central bank manipualtion and intervention as well...