
U.S. investigates market-making operations of Citadel, KCG - randomname2
http://www.reuters.com/article/us-usa-stocks-probe-exclusive-idUSKCN0Y11CJ
======
matt_wulfeck
If I'm buying with limit orders, can someone explain how I'd get a bad deal on
one of these exchanges?

~~~
chollida1
It's a good question. If you are a retail trader, you should almost always use
limit orders.

You can never get a worse fill than what you ask for but the internalizer can
make money off your order and you can miss out on market moves that occur in
the second after you place your order. if you are fine getting price that you
put your limit order in for then as far as you are concerned, you'll be fine.

As with all things market micro structure related, nanex.net has a good
writeup on this. I'm not sure how often this scenario occurs as I've never
worked for an internalizer but its

[http://www.nanex.net/aqck2/What-Every-Retail-Investor-
Needs-...](http://www.nanex.net/aqck2/What-Every-Retail-Investor-Needs-to-
Know.pdf)

Check out the section called "Marketable Limit Orders".

> For example: the Wholesaler receives a retail order to buy 2000 shares at
> $10.03 or better (lower) when the SIP shows a total of 2000 shares offered
> at the best offer price of 10.01.

1\. Wholesaler buys 300 from one exchange at $10.01, and immediately, 1700
shares that were available on other exchanges disappear, causing the best
offer price to move to $10.02.

2\. Wholesaler buys 400 at $10.02, and again, sell orders on other exchanges
disappear, causing the best offer price to move to $10.03.

3\. Wholesaler sells short remaining 1300 shares at $10.0290 to retail
investor, providing a $0.0010 price improvement relative to the $10.03 SIP
offer price at time of execution.

4\. Within seconds, stock reverts back to $10.01 offered.

5\. Wholesaler covers short by buying 1300 shares at $10.01.

> By quickly influencing the price of the stock, perhaps by less optimal
> routing, then directly filling the order at an execution price away from the
> original NBBO at time of Order Receipt, the Wholesaler profits from the
> $0.019 change on 1300 shares ($24.70), less any "price improvement" given to
> the retail investor, less the $4.00 Payment for Order flow paid to the
> Retail Broker (2000 shares x .0020 per share) and $6 in exchange fees
> (maximum SEC fee $0.0030 per share x 2000 shares).

~~~
jsprogrammer
How is step 3 not front running? It would appear to be the very definition;
the wholesaler is executing an order before yours, without your knowledge,
that will affect your order.

Is there an order option to prohibit wholesalers from trading before you?

~~~
cloudjacker
Because the broker isn't doing the front running. That's why it isn't the
currently illegal kind of frontrunning. They sell the data to other
participants who have faster internet connections than you.

Basically any time you send a "smart" routing order, it is actually the least
smart thing to do (unless you REALLY need the liquidity). Your trade order
gets sent to all the exchanges, and ah I don't really feel like explaining it.

tl;dr Someone intercepts your data packet to one exchange, and alters the
liquidity on the other exchanges, so you get a partial fill and then adjust
your order at the slightly worse price.

~~~
jsprogrammer
>Because the broker isn't doing the front running.

In the scenario presented, the wholesaler receives your order, then executes
its own orders, then fills your order based on its own executions (which you
are unaware of).

~~~
tptacek
The wholesaler is required by law to meet or beat the NBBO --- the "exchange
price". If you took your tiny order directly to an exchange, you would not
fare better.

~~~
jsprogrammer
The defense is that this behavior is legally sanctioned front running?

How can a wholesaler guarantee the exchange price in the face of disappearing
orders?

I don't think they can. Instead, the wholesaler fabricates an order at the
limit of your order, then reports the sale to you.

Edit: [rate-limited] Reply to tptacek comment below:

> I can't even tell if you're talking about market or limit orders.

Can you view the context of this thread? I am talking about the explicit steps
listed in the comment I first replied to. Specifically, step 3 [0].

In chollida's description the orders are limit.

Step 3 appears to be, _exactly_ , front-running as explained in my post [1]
immediately above this one.

I asked if anyone could explain how that behavior was _not front-running_. You
responded; indicating that the behavior was according to regulation.

You claim that the wholesaler must give you the best "exchange price", but I
claim that such a guarantee is generally impossible to fill (time-distance-
information problem), and that in the specifics of chollida's described
scenario, the wholesaler is actually front-running you by examining your
unfilled (limit) order and then filling it at the limit (as in, calculus) with
it's own fabricated (perhaps, synthetic, but front-ran, nonetheless) order.

If such a guarantee is generally impossible, then the wholesaler must be
cheating, the law is incompetent, or, both.

[0]
[https://news.ycombinator.com/item?id=11668835](https://news.ycombinator.com/item?id=11668835)
[1]
[https://news.ycombinator.com/item?id=11669193](https://news.ycombinator.com/item?id=11669193)

~~~
tptacek
I don't understand any of these three sentences. Can you reformulate your
argument as a sequence of events, like:

T0: Bob->Schwab: Market BUY 100 ISSX

T1: Schwab->Citadel: Forward Market BUY 100 ISSX

... and so on? I can't even tell if you're talking about market or limit
orders.

~~~
tptacek
If you place a limit order, you're guaranteed that any execution you get will
be at least as good as your limit. That's the point of a limit order.

You aren't entitled to a better price than your limit. If you think you are,
can you provide a sequence of trades in which someone else captures a premium
where they don't take downside risk?

~~~
jsprogrammer
I don't see how taking on downside risk improves the wholesaler's position (in
fact, I think the rationalization is an even more degenerate case).

The fact still remains that the wholesaler has fabricated an order on the
knowledge of a customer's pending order, which affected the execution price of
the customer's order, before the customer could even know that it happened.

Even if the wholesaler sent their order to an exchange and still matched with
their customer, it is still front-running, as the wholesaler is using
knowledge of their customer's order to, essentially, _eliminate all possible
price improvements_.

So, what is being called a "limit order" is just code for "we might just fill
your order at your limit _[when there are no market orders]_ , if we think we
can make money off _[front-running]_ your order with our own".

It would perhaps be acceptable if the wholesaler offered some kind of kick-
back on any profits made, but that would need to be a different kind of order
and I'm not aware of anywhere that does it.

~~~
kasey_junk
Your broker or the wholesaler both have a choice:

1) match the order with the NBBO. 2) send the order to the exchange.

If your limit is better than the NBBO, then they are required by the law to
price improve it. Further, the nature of their agreements with your broker are
such that they are required to maintain a price improvement level (that should
be better than NBBO compliance). That is, incidentally also largely the
requirement the exchanges operate under as well.

A limit order doesn't have anything to do with the existence or non-existence
of market orders, it has to do with your _limit_ and the NBBO. The way they
make money is not by changing the market against your interests, but instead
booking the spread (and in fact the reason they like retail order flow is that
it is naturally uncorrelated so the spread is more even).

The customer does in fact know that this is happening as it is a regulatory
requirement that they disclose it.

I suspect that lots of whole sellers would be happy to kick back profits, if
the retail customer was also on the hook to back the losses. Instead, they
aren't and they get heavily discounted (to the point that it is now free to
trade) trading costs instead.

~~~
jsprogrammer
This is all hand-waving. Neither you or tptacek have altered the fundamental
reality:

>In the scenario presented, the wholesaler receives your order, then executes
its own orders, then fills your order based on its own executions (which you
are unaware of).

>The way they make money is not by changing the market against your interests,

Oh, but they do. They _fabricate an order_ in response to yours. If they did
not act, your order would not have filled at $0.001 under your limit.

>but instead booking the spread (and in fact the reason they like retail order
flow is that it is naturally uncorrelated so the spread is more even).

You can call it whatever you want, the wholesaler is manipulating the market
to their advantage. The wholesaler knows the price is likely to improve, so it
arbitrarily truncates your order and infills its own account with the
improvements.

~~~
kasey_junk
Likely is the important part of your final sentence. They are not acting
against your interests and they are taking on risk in the market to your
benefit.

Is it limited risk? Of course, that's their job.

Finally, I'd ask, what is your point? That the law is flawed? OK, then work to
change it. But know that lots of people have done their own research and come
down in favor of the execution cost benefits of wholesellers.

~~~
jsprogrammer
>They are not acting against your interests

Of course they are. Had they not acted, you would have had a chance at price
improvement. Instead, they took your chance for a token payment.

~~~
kasey_junk
How?

~~~
jsprogrammer
[https://news.ycombinator.com/item?id=11667688](https://news.ycombinator.com/item?id=11667688)

~~~
kasey_junk
I'm going to suppose that your response is fixated on:

> Wholesaler sells short remaining 1300 shares at $10.0290

whereby the wholesaler takes a speculative position wrt the original order?

Are you suggesting that the wholesaler giving you 0.0010 profit on your trade
guaranteed, is working _against_ you? Without regard to your execution costs?

Can you suggest a single chain of messages where you _make_ money on that
trade? What are the chances where that chain of messages is likely?

~~~
jsprogrammer
Yes, I am talking about where the wholesaler fabricates in order in response
to your order. Such behavior is front-running, by definition.

The wholesaler is making off-market trades and treating them as if they are
on-market. The wholesaler would not trade, if it did not think it would
profit. The wholesaler's profit is the difference between their buy-price and
what they actually paid you.

Are you suggesting that if the wholesaler wasn't interdicting orders the
average price improvement for these orders wouldn't be close to the average
profit the wholesaler makes on each instance of such a trade?

~~~
kasey_junk
In the example above, if they had not filled your order at the price improved
price, it would have either filled at the higher price, or rested at the
higher price. In either case you get a higher price.

They do this because they are taking on the risk that the market will
_eventually_ allow them to work out of their short position at a better price
than they paid you. But they don't _know_ that it will do that.

One of the reasons they pay for retail flow is that it on average goes back
and forth, making it more likely that this trade works to their advantage.

None of the profit of that trade came from you the limit order provider. It
came entirely from the average spread.

~~~
jsprogrammer
>In the example above, if they had not filled your order at the price improved
price, it would have either filled at the higher price, or rested at the
higher price.

Or, you know, improve beyond the $0.001/sh the wholesaler paid.

~~~
kasey_junk
No, it wouldn't have. That's the point of why they improved you. By that point
there was no one else available to do it.

~~~
jsprogrammer
So, you wait around for an order at your limit or better. There is nothing
that says your limit order must fill, even if no on is available.

~~~
kasey_junk
It won't be better, that's not how it works.

At the point that they filled you at 10.299, the market is set at 10.30. 1 of
2 things can happen. Either there is enough volume to fill you at 10.30 that
your order is fully filled at 10.30 (worse than the wholesaler gave you) or
there isn't and some of your order fills at 10.30 (worse than the wholesaler
gave you) and you have now set the new market level and rest your order. Once
your order rests, it will not be improved and will either fill at 10.30 (worse
than the wholesaler gave you) or it will be cancelled (you didn't get what you
wanted).

Most people placing a limit order like that would prefer the outcome that the
internalizer provides, if you don't, great use a broker that allows you to
route direct. But its certainly not front-running because the internalizer
acted directly _in_ your stated interests, not _against_ them.

------
chollida1
I consider this to be a big deal. Most people don't realize that retail
orders( orders from an ordinary person) almost never reach an exchange.

Funds like Citadel and KCG pay the banks and brokerages( Schwab, Vanguard,
etc) hunderes of millions per year to get their order flow. Here's a reuters
article about Schawb's pay for order flow:

[http://www.reuters.com/article/schwab-ceo-proposal-
idUSL1N0O...](http://www.reuters.com/article/schwab-ceo-proposal-
idUSL1N0O12EC20140515)

> Trading companies, including market makers such as UBS , KCG Holdings and
> hedge fund Citadel LLC, are willing to compete for retail investors' orders
> because they are considered "dumb money" that shows the professionals where
> markets are headed.

> In reporting first-quarter earnings last month, Schwab said that it expects
> to earn about $100 million this year from selling client orders, the first
> time it gave out a specific number, and higher than the estimate it had
> given a few weeks earlier to Reuters.

and here is the breakdown of their order flow:

[https://www.schwab.com/public/schwab/nn/legal_compliance/imp...](https://www.schwab.com/public/schwab/nn/legal_compliance/important_notices/order_routing.html)

The funds then get a free look at these orders where if they are beneficial to
them they can fill the order, or if they aren't, then they can pass the order
onto an exchange.

If you thought flash orders were bad, these are much worse and flash orders
were discontinued years ago.

If you thought HFT funds were bad then consider atleast HFT funds have to put
their orders out to the market and take the risk that they'll get rolled over
when the market moves. ie they put their money where their mouth is and they
compete every day on a level play ground with the rest of the market makers.

These internalizers often hold orders up for up to a second, before they
choose to fill them or let them go and when you consider that the IEX delay of
350 micro seconds, not milliseconds, is considered contentious you get a good
idea of just how scummy things have gotten.

in an unrelated piece of news Reuters today wrote a piece showing the top paid
hedge fund managers. Citadel's founder Ken Griffin can in first, taking home
1.7 Billion last year. This is really the DOJ taking on the biggest players on
wall street.

[http://www.reuters.com/article/us-hedgefunds-compensation-
id...](http://www.reuters.com/article/us-hedgefunds-compensation-
idUSKCN0Y11D1?feedType=RSS&feedName=businessNews&utm_source=Twitter&utm_medium=Social&utm_campaign=Feed%3A+reuters%2FbusinessNews+%28Business+News%29)

~~~
yummyfajitas
_The funds then get a free look at these orders where if they are beneficial
to them they can fill the order, or if they aren 't, then they can pass the
order onto an exchange._

This is simply false. For example, IB describes the mechanism here:

 _Liquidity Provider Relationships: IB has entered arrangements with certain
institutions under which such institutions may send orders to IB at or near
the NBBO. These orders are held within the IB system and are not displayed in
the national market. If another IB customer order could be immediately
executed against such an order held in the IB system (at the NBBO), the orders
may be crossed and the execution reported to the National Market System..._

[http://www.arcacapitalinvestments.com/new/arcacapitalinvestm...](http://www.arcacapitalinvestments.com/new/arcacapitalinvestments/images/Rule%20606%20Interactive%20Brokers.pdf?advisorid=4024665)

So no, the liquidity providers don't get a "free look". They get to place
orders (before you do) and your brokerage fills them if there is a price
match. The price is always at least as good as in the national markets, modulo
the limitations of physics/CAP theorem/etc.

The purpose here is to enable price discrimination - you pay a lower price for
liquidity (since you have less adverse selection), Goldman pays a higher price
(since they have more adverse selection).

~~~
chollida1
> This is simply false. For example, IB describes the mechanism here

Well to be fair, i never mentioned IB, you did. I'm correct on this issue.
Let's leave IB out of this as what you describe does happen but is a
completely separate issue from selling order flow.

First off Schwab has already publicly admitted they sell their order flow.
I've talked to 4 Canadian banks who do the same.

The internalizers who buy the flow are then allowed to either fill the order
or pass it along, to the market, they get to see the order before it gets to
the market, this is the free look i was talking about.

You may not be aware this happens but it does. I've literally talked to people
on both sides of this who freely admit what they do. its currently legal, but
I don't think it will be for much longer.

~~~
yummyfajitas
Selling order flow refers to the exact mechanism IB just described. It's
mechanically no different from a dark pool (such as IEX, the heroes in Flash
Boys).

If you have evidence otherwise, by all means post documentation _describing
the specific mechanics of how matching works_. Simply citing news articles
that use the word "sell order flow" doesn't count.

I just cited IB because their docs are very detailed and because I know them
well.

~~~
mrchicity
You two are talking about different things. They are similar but the mechanics
are different. IB's example is an internalization pool where liquidity
providers _may_ post quotes and potentially fill within the NBBO when they
have a desire to match/improve the quote.

The KCG and Citadel business is called wholesaling. A broker like Schwab has
market orders or marketable limit orders from customers. They make an
agreement with a wholesale market maker like Citadel to fill _all_ of those
orders up to a certain size possibly, within the NBBO, in exchange for a fee
and some price improvement requirements.

So imagine you're Citadel. You have a stream of incoming orders that you
commit to fill at the current market prices with a bit of improvement. If the
order flow is small, you just sit on the delta waiting for flow in the other
direction or trade out patiently on exchange to make a spread. If the flow
becomes largely imbalanced, you can liquidate the delta aggressively on the
public market to hedge at a very small cost. Say the NBBO is 100.50 bid 100.51
offer and you just sold 500 shares at 100.5099 and bought 2000 at 100.5001.
You can dump the 1500 residual on the exchange bid or in dark pools, whatever,
and all you lose is the price improvement you gave and fees, which are smaller
than the spread you make on a "good" trade.

In effect, the wholesaler is cherry picking and getting a cheap option to make
a spread. All the small retail trades that are easy to capture spread on get
siphoned off the exchanges, and they're left with only the imbalanced toxic
ones. This is good for the wholesaler, good for the retail trader (he gets a
bit of price improvement and lower trading commission), bad for the exchanges,
and bad for on-exchange market makers like most HFT firms.

It's arguably "fair" to price uninformed flows differently, it's very common
in some markets like FX, but locking that up behind opaque pricing agreements
where only a handful of firms participate isn't. Most market making firms
would gladly compete to offer even more sub-penny price improvement to retail
trades, and there are even a few exchange programs that tried to do this but
never got much traction.

~~~
yummyfajitas
Every time I've looked into the mechanics of paying for order flow, it was
just a pay-to-play dark pool with certain extra requirements (e.g. you must
match X% of trades). Do you have documentation on a brokerage that provides
some sort of "first peek" mechanics that might allow frontrunning?

I think we are in agreement that the main purpose of buying order flow is to
price discriminate based on delta toxicity.

~~~
mrchicity
I am not saying the mechanics allow front-running. It is just different from a
dark pool or exchange in that the wholesaler guarantees execution and has some
discretion over how to provide it. It's not as if Schwab pings a bunch of
internalizers to say "hey, can you fill this at the NBBO?" and then routes out
themselves if nobody says yes. The wholesaler must fill the order whether they
want it or not, and can either wear the delta, fill it from their own
inventory, or execute in the market to facilitate the trade as riskless
principal. The wholesaler gets contingent orders like stop market and stop
limit orders and is responsible for executing them as well. It is more like
having the retail broker outsource their execution similar to how a fund may
have a bank desk execute orders on their behalf, except a bank desk usually
has even more discretion over execution.

Hate to link to the Themis blog, but they cite the SEC here describing how
internalizers, not retail brokerages, routed sell orders out to exchanges on
May 6th: [http://blog.themistrading.com/2010/10/the-internalizers-
and-...](http://blog.themistrading.com/2010/10/the-internalizers-and-the-
flash-crash-let’s-talk-real-villains/)

------
atemerev
HFT is nothing new. It is just the automated version of regular market making.
As long as there are several MMs, they will compete for execution speed.

------
randomname2
Is there any reason the DOJ should not subpoena the code here?

