Tuesday, 17 January 2017

A tale of two cities' firms

Not so comical?
(source: Wikipedia)
"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way - in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only."

Charles Dickens is no less relevant in 2017 than he was in 1859. Yeah, the quote is a bit delightfully long.

The big news from last week was the Moody's gentle US$864m wrist slap and general escape. However, the micro news was a bit more stimulating to me. The SEC came out with two interesting finalisations of matters.

Firstly, ITG's Frank Troise's valiant attempt to turn around belief struck a hiccough with ITG's well telegraphed ADR fiasco being finalised by the SEC ($US 24.4M). Secondly, Citadel, or more specifically Citadel Execution Services (CES) as part of Citadel Securities LLC, was poked in the ribs for misrepresenting how some of its wholesale internalisation, or Payment For Order Flow (PFOF), worked ($US 22.6M). There was a very important difference between the two findings. ITG was doing something wrong. CES was not found to be doing something wrong with respect to transactions but, rather, was found to be miscommunicating what it was doing. Let's meander through both of these.

New York, New York

It's just on a year since Frank Troise took over at ITG. He has made significant progress in changing the focus of the firm back to its clients. The most important action undertaken was closing the proprietary trading and lending businesses down. ITG had been called to account for their pool abuses with their previous settlement of $US 20.4M. This new settlement may finalise the lending abuses and Troise's aim to deflect the settlement to historical legacy is fair enough. It remains to be seen if the strong language from the SEC,
"Many of the ADRs obtained by ITG through pre-release transactions were ultimately used to engage in short selling and dividend arbitrage even though they may not have been backed by foreign shares."
results in any other parties being held to account. The large missing item for ITG is that it has not been properly held to account for the historical lying to its customers about being an agency only business. ITG did infact engage in proprietary trading in the same or similar products to many of its clients. Bob Gasser misled a US Senate Committee in 2012 when he claimed ITG did not engage in proprietary trading,
"ITG is not a market maker, and we do not take on proprietary positions. In other words, we do not have “skin in the game...”
ITG closed their proprietary trading business in 2016. I don't think proprietary trading is necessarily a bad thing in a diversified financial services business, but lying about it is definitely bad. When you're caught out doing something you said you're not doing, the sensible thing is to get rid of it so your customers may grow better trust in your integrity. ITG seems a bit swollen in head count with ageing products but at least it has a chance now if it can lift its game. However, the deception associated with ITG's proprietary trading has not yet been accounted for by any regulator. We'll have to wait to see if that penny drops.

ITG's share price has been doing OK with reasonable interest being associated with sizeable positions. Now revenues may see some improvement through some of the diversification being promised. It is also possible significant head count reductions could see a much better ROI from ITG's legacy IP even if revenue faded. That is, I'm not sure ITG would perform much worse with only 250 people instead of over 1000. 2017 is going to be "interesting" for ITG staffers you'd expect. Time will tell if New York's ITG is a value trap or not.

A cover from the 1859 Serial. Has the SEC started another serial?
Is there more to come? (Source: Wikipedia)

By the inland sea: the other city

In a tale from the city of Chicago, Citadel had a bit of a different diagnosis and prognosis from their SEC fine. After a detailed look under the covers, the SEC found CES made misstatements about how its executions worked in some circumstances. Its operations were not found to be at fault, but its marketing was. That's an important distinction. So how bad was it? Is this similar to ITG deceiving its customers about it pool operations or prop trading? It looks quite different to me.

After trying to parse to the SEC order I found myself left without all the detail to make a proper judgement of the situation. There are are curious twists in the saga worth discussing however. I was certainly left with the impression that there was simple miscommunication going on rather than anything nefarious. The FastFill aspect goes to the heart of PFOF. More about that below as I feel the juxtaposition of PFOF and best execution responsibilities particularly troublesome. The other procedure focused upon by the SEC was CES's algo called SmartProvide. There is not enough detail to evaluate SmartProvide. The scant details could even be interpreted as a gain for the customer, though less likely than otherwise. Nevertheless, CES was penalised for saying it was doing X and instead doing mainly X with a dash of Y.

The scale of the Citadel misgivings was pretty small beer according to the SEC. They point out that CES does about 35% of retail execution in the US. Yet in the period covered from "late 2007 through January 2010" the SEC disgorged $5.2M for those two and a bit years. It is interesting to try to put that in a per customer perspective. CES is one of the big internalisers, for example they handle most of TD Ameritrade's volume. TD Ameritrade is one of the big five retail brokers (Nov 2015). This shows north of 50 million or so retail accounts are likely for the big five.  The SEC counted 109 million retail and institutional brokerage accounts in 2011. It would thus not surprise if there were approximately 100 million retail brokerage accounts in the US. So if the CES penalty was over 35% of those it would equate to about $0.075 annually.  Yes, seven and a half cents, per account per year. That calculation is arguably quite a bit wrong, but you get the idea. The scale is nevertheless appropriate. The profit attributed to those algos was pretty small beer.

There are a few interesting facets to all of this. Let's look at Fast Fill: from the SEC order,
"10. One strategy, known as FastFill, was triggered when the best price from one or more of the depth of book feeds that FastFill referenced was better than the best price disseminated by the SIP feed. Assuming all other eligibility conditions were met, FastFill immediately internalized a marketable order at the SIP NBB or NBO, as applicable, or better. 
11. For example, if CES was handling a marketable order to buy shares, and the SIP best offer was $10.01, and the best offer from one or more of the depth of book feeds was $10.00, FastFill immediately internalized the order using the SIP offer of $10.01 per share. FastFill did not internalize at or seek to obtain through routing the better $10.00 price from the depth of book feeds."
This is basically saying that if the SIP was behind the direct feed, the customer got the SIP and CES would do its best to get something better for itself. That may not have always worked out for CES, but it probably did. This is the direct feed (DF) versus SIP feed, a so called latency arb that isn't, but is frowned upon at an ATS or exchange. I'm not sure if this was improper for an internaliser under rules at the time. I don't think it was. Newer rulings, subsequent to January 2010, may have an impact in current interpretations. The SEC did not take the view it was improper, they just wanted proper disclosure. For example, say that you used some smart ML to determine the price was about to change and thus filled your clients over the spread with the expectation you would do better as you hedge, but with less certainty, is that wrong? At what price is innovation? It quickly gets cloudy.

SmartProvide gets murkier. The SEC order doesn't give full details but enough to know that you can't really make a judgement,
"12. The second strategy, known as SmartProvide, was triggered when the SIP NBB or NBO, as applicable, was better than the best price from at least one of the depth of book feeds. SmartProvide did not internalize at the SIP price, nor did it seek to obtain an execution at that price by sending an order to the market. Instead, assuming all other conditions for order handling by SmartProvide were met, SmartProvide would route a non—marketable order to the market.
13. For example, if CES was handling a marketable order to buy shares, and the SIP NBO was $10.01, and the best offer from one or more of the depth of book feeds was $10.02, SmartProvide would send a buy order to be displayed in the market at a price less than $10.01, such as $10.00. This order would be displayed for up to one to five seconds, depending on the size of the order. If this order received an execution, the customer order would benefit from the execution at the better price (i.e., the shares purchased by the customer would be at a price at least one penny better than the NBC). This occurred for approximately 18% of the shares handled by SmartProvide. If the order did not receive a full execution from this routing, CES’s algorithms reassessed the handling of the remaining shares, and could either internalize or seek to obtain an execution in the market. Some of the orders that CBS internalized after SmartProvide displayed an order in the market on their behalf received a price that was worse than they otherwise would have received in the absence of SmartProvide."
So, 18% of trades were executed at a better price. The customer benefited in those cases. Did that offset the other 82%? It is unclear. It probably didn't but it could have if the average 18% gain was 4 times larger than the 82% average displacement. We don't have enough information to know for sure. Also, it was not a simple DF versus SIP equation here as the decision was specific to order size and which stock as to how the algo assessed the decision making. Here is how the SEC described the SmartProvide trigger,
"Triggering Event for SmartProvide 
34. SmartProvide was triggered when the SIP NBB or NBO, as applicable, was better than the best bid or offer from one or more depth of book feeds. SmartProvide referenced only one depth of book feed for many securities and fewer than all of the depth of book feeds for other securities. Accordingly, at times, SmartProvide was triggered when the SIP NBB or NBO, as applicable, was from an exchange whose depth of book feed SmartProvide did not reference. In addition, SmartProvide sometimes could be triggered when the difference existed between the SIP and only one of the depth of book feeds SmartProvide referenced, and not the others.
35. For example, in the case of a marketable order to buy shares, SmartProvide could be triggered if the SIP NBO was $10.01, and the best offer from one or more of the depth of book feeds was $10.02, even though the best offer on one or more of the depth of book feeds from one or more other exchanges was $10.01."
So, it was a bit more complex than DF versus SIP. There was some judgement as to which DFs got used, often only one. However, this is not what was disclosed,
"40. During the relevant period, CES provided a written disclosure to certain retail broker—dealer clients that described a market order as an “[o]rder to buy (sell) at the best offer (bid) price currently available in the marketplace,” and made other, similar representations to its clients. As discussed above, these statements suggested that CES would either internalize the marketable order at, or seek to obtain through routing, the best bid or offer from the various market data feeds CES referenced. These statements were materially misleading in light of the way that FastFill and SmartProvide functioned."
Sometimes a client got a much better price by not crossing the spread thanks to SmartProvide. However, that is not what paragraph 40 says. It is wrong to say something and do another even if it's advantageous to the client. So, the customers still received SIP NBBO or better but the marketing didn't correctly represent the ever changing algo operations. This CES story is not simply a black hat versus white hat story.

Best execution versus Payment For Order Flow

If you were to do best execution by policy, I'd argue payment for order flow could not exist. By definition the wholesaler is getting money, say $0.002 per share, for handling the order. The wholesaler is not a charity. They are expecting to receive more than the fee they pay for the execution or the execution information as a statistical whole. They need to make a profit.

That is, fundamentally, the customer is not getting best ex in a holistic fee and execution sense. The broker could make the same decisions as the wholesaler. Then, instead of losing the wholesale fee and the wholesale profit, the customer could receive that cost as a benefit. This is what I mean by best ex and PFOF being in tension. It is also just weird that US retail broking is just not really all that concerned with, you know, broking. Maybe it's just me.

All that said, there are obligations on the broker to shop for the appropriate wholesaler and to monitor and report on such. There is some competition and tension in the market place even though big wholesalers are very few in number. To me, PFOF, like the order protection rule, had a point in days gone by, but it appears to have over stayed its welcome.

Europe does best ex better than the US. In the US you get an audit and profiled against the SIP. The US has specific procedural elements, such as the order protection rule, you must take heed of. In Europe there is a better approach where best execution is a policy. Thus best ex is a little woolier but it ostensibly takes the gaming of specifics out of the equation. However, a lack of enforcement makes for weak policy in the Europe but enforcement seemingly improves over time. Canada has learnt from the US and European experience and I think it has struck a better policy / execution balance. The SEC could learn a little from IIROC but are unlikely to look North for inspiration in their parochial world.

The order protection rule is ripe for change as, not only is it tired, incumbents benefit if it is retired. PFOF is unlikely to ease out of the picture as large brokers and wholesalers benefit, and arguably, the smaller brokers still benefit by being able to outsource their operations as the NMS gets ever more complex. However, best execution and PFOF will continue to remain oxymoronic to me.

Happy trading,



  1. Can you clarify something for me?

    Smart Provide says it could kick in when a DF was worse than the SIP. Does that mean it could apply if *any* of the referenced Direct Feeds were worse than *any* SIP quote? Or only when a referenced direct feed was worse than its *corresponding* SIP quote?

    For example, assume the SIP NBO in GOOGL is:
    100 NSDQ @ 929
    100 EDGA @ 930
    100 ARCA @ 931

    If Citadel referenced the EDGA Direct Feed and saw a price of $929 (matching the SIP EDGA quote), could they still apply Smart Provide because it's worse then the NSDQ quote @ $928?

  2. You probably have already, but I recommend reading Stanislav Dolgopolov's post here: http://clsbluesky.law.columbia.edu/2017/05/05/the-citadel-settlement-off-exchange-market-makers-and-giant-brokerages/comment-page-1/#comment-296916.

    The more I think about Citadel's algos, the more I am stunned that the SEC didn't call this a Best-Ex violation. I'll concede that FastFill was probably not a violation until FINRA's guidance (Footnote 12: http://www.finra.org/sites/default/files/notice_doc_file_ref/Notice_Regulatory_15-46.pdf).

    As you point out, filling at the prevailing market price even when you think/know the price will get better (FastFill) seems somewhat aligned with BestEx up until the FINRA Guidance. However, REFUSAL to even TRY and fill at the prevailing market is purely an operation failure. Any broker could do this and is no way dependent on innovation* or any kind of value add for the client.

    In fact, is it that unreasonable think Citadel only applied SmartProvide when a rebate venue was unavailable at the NBBO? Wouldn't they do this by visibly posting 1 cent away from the NBBO on a traditional ECN, risking an impact on the NBBO? I find it a little peculiar that the SEC provided a specific number of improved fills (18%) but neglected to mention how many were filled at worse prices (some)? I also find it curious that there are no stats on how much price improvement the client received using SmartProvide. My hunch is that the client received the minimum tick of improvement on every order (usually a penny) in order to maximize the probability of obtaining the rebate. I'd also love to know what percent of marketable limit orders were routed immediately when a rebate venue was available versus when one wasn't.

    *There is one exception that could be deemed innovation, but it's actually a much worse abuse of BestEx: Suppose Citadel compared feeds and determined the quote was crumbling (a la IEX). If they were really acting in their clients' best interests they would be as aggressive as possible in obtaining the current NBBO price because they think/know it won't be available much longer. But instead they are posting a visible at or inside the NBBO? That makes no sense! Unless, perhaps, they are intentionally giving the stock a little nudge so the NBBO widens, at which point Citadel can either fill against a rebate exchange (which likely wouldn't have been available during a crumbling quote situation) or internalize at an inferior price.

    Rant over. Have a good weekend.