As reported in ValueWalk on February 25, high frequency trading firm Virtu on Monday filed for an initial public offering, seeking to raise $100 million. With a star-studded list of many of the most connected people on Wall Street and in algorithmic trading behind the effort, and an unheard-of 99.9999% win percentage on its trades, does the HFT firm have a magic formula?
99.9999% win percentage with over 90% of trading days generating over $1 million per day
According to the S-1 form filed by the company, in 1,238 days of trading the firm only had one losing day and average with over 90% of those days generating over than $1 million in revenue. The company has been profitable, reporting $182.2 million 2013 earnings on revenue of $623.7 million last year – while paying $433.4 million in cash distributions to its members. In 2012 the firm had $87.6 million earnings on $581.5 million in revenues.
The question for investors is will this incredible revenue growth and winning trade ratios continue in an industry where trading strategies can become out of date as quickly as the trades are executed?
To understand this one must understand the market environment for HFT firms as well as identifying exactly what Virtu’s magic formula might be and if it is sustainable.
Is the magic formula an algorithm or human connections?
In traditional high frequency trading, the strategy makes a directional bet in markets, yet Virtu says its strategy is “market neutral.” The firm is a market maker across all major stock markets, derivatives exchanges and certain dark pools around the world, having a strong and even distribution of trading venue. The key could be the rebates the firm receives from each of the exchanges and the preferential treatment it enjoys.
Authorized exchange market makers are entitled to receiving rebates from participating exchanges because they provide two-sided liquidity. In addition to trading rebates, authorized market makers also can receive priority treatment on certain exchange order books. When a market maker places an order it can be given preferential execution before other non-market makers who may have had their orders sitting on the exchange for a longer period of time. This “market maker” designation, or more specifically the rebates and preferential exchange order treatment they receive, could be critical to the success of the firm. It should be noted that the market maker designation is typically not offered to pure high frequency trading firms.
While Virtu’s exact trading algorithms are unknown, with preferential order treatment if the trading algorithm identified a large block of orders entering the market and was able to place their trades in front of these orders by as little as a millisecond, then it could literally generate millions in “market neutral” trading profits. But it should be noted that special designations and advantages the exchange provides the “market maker” could be critical to the venture’s future success.
A key point in the S1 is the disclosure that the Commodity Futures Trading Commission had been reviewing the firm’s participation in exchange rebates. “The CFTC is looking into our trading during the period from July 2011 to November 2013 and specifically our participation in certain incentive programs offered by exchanges or venues during that time period,” the report noted on page 30.
The question for Virtu is how does it maintain its market advantage while HFT firms all around it are finding difficulty?
Virtu’s star-studded board of directors and employees
Virtu’s board of directors is led by its well known founder Vincent Viola, the former chairman of the New York Mercantile Exchange, which was purchased by the CMEGroup in 2008. Chris Concannon, now executive vice president and partner at Virtu, was previously executive vice president at Nasdaq and had worked as an attorney at the Securities and Exchange Commission. Two former JPMorgan investment bankers who focused on securities and exchanges are at Virtu, including Joseph Molluso and William Cruger, who are listed in the firm’s S1 as having a high percentage ownership in the firm. Other notables listed with an ownership interest include Dick Grasso, former chairman and chief executive officer of the New York Stock Exchange; Jack Sander, former chairman of the Chicago Mercantile Exchange; and John P. Abizaid, former US Army General and the longest serving commander of the US Central Command, now a member of the Council on Foreign Relations.
As previously reported in ValueWalk, New York-based Virtu is a major market maker and high frequency trading operation, executing millisecond bets in nearly 200 stock, futures and currency markets worldwide. High frequency trading has come under fire of late due to the ability to move markets and its tendency to be involved in flash crashes. Many HFT firms have used their knowledge of exchange market making systems to develop strategies that game the system. As recently as this January a flash crash in gold, traded on the New York Mercantile exchange, was attributed to a sophisticated high frequency trading operation, as reported exclusively in ValueWalk.
Traditional market makers have been having serious difficulty generating profits as the bid ask spread in the markets traded continues to shrink, a point noted in Virtu’s S1. For a market maker or HFT firm to generate a standard profit in this market environment is notable let alone generate a 99.9999% win percentage with 90% of trading days generating $1 million or more in revenue. Keeping their trading advantage is the key challenge for the firm and there are many issues that could diminish this apparent market advantage.
Regulatory issues should be a key concern of any investor seeking entry into this market, as is the tendency for a trader to gain then lose a trading edge. One trading edge had always been speed to market, but with the speed advantage now cut to milliseconds and competition piling up in what has become a “commodity,” speed alone cannot be relied upon to be a primary differentiator.
Virtu selects Nasdaq over CMEGroup competitor ICE
Virtu chose the NASDAQ OMX Group, Inc. (NASDAQ:NDAQ) to launch the IPO as opposed to the NYSE Euronext (NYSE:NYX), which is owned by the Intercontinentalexchange Group Inc (NYSE:ICE), a fierce competitor of the CME Group Inc (NASDAQ:CME). This would be the second IPO for an algorithmic trading company, following the Knight Capital Group filing an IPO in 2012.
After the IPO, the speculation is that Virtu could engage in acquisitions in the algorithmic trading space.