The high frequency trading firm, Virtu Financial, just released their S-1 statement in anticipation of their upcoming IPO. Virtu has remained extremely secretive over the past few years but this S-1 statement shines a light on them that they may wish was never shone. To be fair, we have no opinion on the valuation of Virtu. We have no idea on whether it will be a good stock if it successfully manages to IPO, nor do we care. We do care however about many of the statements that Virtu published in their S-1. While the financial press has picked up on the fact that Virtu has lost money only once in the last 1,238 days, this is not where we want to focus our attention. Rather than focus on the results of their mousetrap, we’re more interested in knowing how they built that mousetrap and the risks associated with it.
We read through the entire S-1 and have highlighted 12 facts that you probably didn’t read in the financial press:
1 - The more fragmented the market, the better it is for Virtu
“While we believe this fragmentation and related competition have been beneficial to all market participants, leading to more compressed bid/ask spreads and creating deeper liquidity, they have also created greater complexity and has required electronic market makers to expand their infrastructure to connect with more venues, which we believe will enable larger firms with scalable infrastructure, like us, to capture more of these opportunities.”
2 - When the spigot runs dry, just find another spigot
“We believe that the full implementation of the European Markets Infrastructure Regulation and the Dodd-Frank Act in the U.S. will increase transparency, liquidity and efficiency in global trading markets and encourage the further development of trading opportunities in certain asset classes in which highly liquid electronic markets remain limited or nonexistent due to historical reliance on bilateral voice trading and other inefficient processes. The migration of these products to electronic trading will provide us with an opportunity to deploy our technology in asset classes that are not accessible to us currently including, for example, interest rate swaps, interest rate swap futures, CDS index futures and OTC energy swaps.”
Reg NMS was the cause of today’s fragmented equity market and no doubt there were tremendous profits made by some firms who were able to exploit the fragmentation when it first occurred. Unfortunately, it seems that the swaps market, with the introduction of numerous swaps execution facilities (SEF’s), seems to be following the same path as the equities market did in 2007 and we’re sure there are some firms just licking their chops while waiting to exploit this new fragmented market.
3 - Virtu enjoys mega-tier rebates from their exchange friends
“Our significant volumes generally place us in the top tiers of favorable brokerage, clearing and exchange fees for venues that provide tiered pricing structures”
4 - If they feel like they are making too much money, they will just shut it down
“If our risk management system detects that a trading strategy is generating revenues outside of our preset limits, it will lockdown that strategy and alert management. In addition, our risk management system continuously reconciles our internal transaction records against the records of the exchanges and other liquidity centers with which we interact. As a result of our successful real-time risk management strategy, we have had only one losing trading day since January 1, 2008.”
5 – They like to quote…a lot
“Our platform incorporates market data and evaluates risk exposure on a real-time basis to update outstanding quotes often many times per second, enabling us to offer competitive bid/ask spreads. Our high degree of automation reduces our costs, and we believe our cost per trade is as low as or lower than any other market participants.”
Does it seem fair that Virtu takes advantage of their super low cost model while jamming in as many quotes as they want without penalty? In the meantime, the rest of the industry has to constantly update technology to process all these quotes while exchanges then simply pass these costs along to the end users – all of us.
6 - So much for small cap liquidity
“We seek to minimize our liquidity risk by trading only in highly active and liquid instruments”
Reminds us of that Andy Haldane quote: “HFT adds liquidity in monsoon and consumes it in a drought.”
7 -The Who’s Who of HFT
“Our major competitors continue to be large broker-dealers, such as Bank of America Merrill Lynch, Citigroup, Goldman Sachs, Morgan Stanley, UBS, and, and niche players such as Citadel, DRW Holdings, Hudson River Trading, IMC, KCG Holdings, Optiver, Peak6, Susquehanna, Timber Hill and Wolverine Trading. Some of our competitors in market making are larger than we are and have more captive order flow in certain assets.”
“Our competitors range from sole proprietors with very limited resources to highly sophisticated groups, hedge funds, well-capitalized broker-dealers and proprietary trading firms or other market makers that have substantially greater financial and other resources than we do.”
8 - Customers, we don’t need no stinkin’ customers
“We believe our lack of direct customers and customer accounts allows us increased flexibility as we face fewer constraints in reallocating resources to pursue market opportunities as they arise… Our registered broker-dealer subsidiaries do not carry customer accounts and are therefore exempt from otherwise applicable SEC requirements relating to the protection of customer securities and the maintenance of a cash reserve account for the benefit of customers.”
9 - A little nepotism never hurt anyone
“We employ the son of Mr. Viola, our Founder and Executive Chairman, as a trader, and he received total compensation from us for the years ended 2013, 2012 and 2011 of $510,703, $636,066 and $391,538, respectively.”
10 - Virtu discovered one of those accounting irregularities and it may not be fixed yet
“In connection with the audit of our consolidated financial statements for the year ended December 31, 2013, we and our independent registered public accounting firm identified a material weakness in our internal controls over financial reporting. This material weakness related to our inability to prepare accurate financial statements, resulting from a lack of reconciliations, a lack of detailed review and insufficient resources and level of technical accounting expertise within the accounting function. Although we have hired senior accounting and finance employees, reallocated existing internal resources and retained third-party consultants to help enhance our internal controls over financial reporting following reviews of our accounting and finance function conducted by members of senior management and by a third-party consultant, there can be no assurance that we will remediate this material weakness or avoid future weaknesses or deficiencies.”
This is a big one and one that should raise lots of eyebrows. Jonathan Weil over at Bloomberg found it and wrote a very good piece warning investors about the consequences of the lack of proper accounting controls.
11- Better hope that one of those software bugs doesn’t show up
“Our reliance on our computer systems and software could expose us to great financial harm if any of our computer systems or software were subject to any material disruption or corruption and could compromise any competitive advantage we have based on our proprietary technology.”
Mark Cuban, who has been a vocal critic of HFT, once said :”The only certainty in the software world is that there is no such thing as bug-free software.” Virtu had better hope that he is not proven correct.
12 - The JOBS Act helped them go public
“We qualify as an “emerging growth company” under the JOBS Act.”