New SEC Chairman Sets Sights on Citadel Securities and Virtu

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MARKETS | FINANCIAL REGULATION SHARE New SEC Chairman Sets Sights on Citadel Securities and Virtu Regulator questions payment for order flow, in which firms pay brokers such as Robinhood for opportunity to execute investors’ orders

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SEC Chairman Gary Gensler, testifying before Congress by video last week, criticized the system that funnels orders to electronic-trading firms. PHOTO: U.S. HOUSE COMMITTEE ON FINANCIAL SERVICES

By Dave Michaels and Alexander Osipovich May 9, 2021 12:00 pm ET

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WASHINGTON—The electronic-trading ﬁrms Citadel Securities and Virtu Financial Inc. VIRT 1.41%▲ have become pillars of the stock market in recent years, rivaling the role played by stock exchanges.

Wall Street’s new top regulator is putting pressure on them by questioning a key service they provide: executing the orders of millions of ordinary investors whose trades go to their black boxes, instead of being routed to public exchanges.

Testifying before Congress last week, Securities and Exchange Commission Chairman Gary Gensler criticized the system that funnels orders to Citadel Securities and Virtu, which pay MOST POPULAR NEWS

for the opportunity to trade with retail stock and options orders. Mr. Gensler said such Americans Up and incentives—called payment for order flow—represent a conflict of interest for online 1. Moved During the Pandemic. Here’s brokerages, which collectively make billions of dollars a year from the practice. He voiced Where They Went. concern that the trading firms handling most individual investors’ orders control too much Melinda Gates Sought of the business. 2. Divorce Lawyers in 2019 Total order-flow payments made in first In an interview with CNBC on Friday, Mr. three months of 2021 Gensler went further, comparing the retail Seychelles Sees 3. Renewed Covid-19 $0 million $200 $400 $600 wholesalers unfavorably with public exchanges Surge Despite Vaccinations Citadel whose prices are considered “lit” because they Securities appear publicly for all traders to see. Catholic Schools Are 4. Losing Students at Record Rates “A lot of these are really just going to the Susquehanna wholesalers, they are not as lit, they’re not as California Governor competitive,” he said. “So it’s not as clear we 5. Proposes Tripling Spending on Stimulus Virtu are actually getting best execution in an unlit, Checks internalized wholesaler as contrasted to the lit markets.” MOST POPULAR OPINION Wolverine It is unclear whether the SEC would go as far as Opinion: Robert 1. Mueller’s Revenge banning payment for order flow. Doing so would Note: Includes both equities and options order flow. Source: Bloomberg Intelligence make it harder for brokerages to offer zero- commission trading, and the agency has Opinion: The Fed Is 2. Playing With Fire reviewed the practice several times in the past without prohibiting it. Brokers and traders say routing orders to wholesalers benefits investors. 3. Opinion: The Real People close to Mr. Gensler said his regulatory instincts come from his long experience in Infrastructure Problem markets, including years at Goldman Sachs Group Inc. Mr. Gensler puts more trust in regulated trading venues that post prices publicly and is generally skeptical of less- Opinion: Joe Biden, 4. Labor Economist transparent systems that give intermediaries more power to set prices.

“He is certainly looking at it more critically than the SEC has in recent years,” said Larry Opinion: China, Fauci Harris, a University of Southern California professor and former SEC chief economist. 5. and the Origins of Covid “Gary has correctly identified a serious conflict of interest between the interests of the broker and of its clients.” RECOMMENDED VIDEOS In the first three months of 2021, Citadel Securities paid more than $475 million to brokers Video: Israel and Gaza for handling their customers’ stock and option orders, making it the biggest source of 1. Militants Exchange payment for order flow, according to Bloomberg Intelligence. Among the largest recipients Attacks, Dozens Killed

of such payments were TD Ameritrade, owned by Charles Schwab Corp. SCHW -0.63% ▲ , Roblox: The Free and Robinhood Markets Inc. 2. Videogame Platform That Became a $45 Billion Public Related Video Company

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Payment for order ﬂow has surged as day trading has grown more popular during the Covid-19 pandemic and as U.S. brokerages have dropped upfront commissions, making them lean more on selling order ﬂow to generate revenue. The practice has also drawn fresh scrutiny after social-media-fueled trading frenzies in stocks such as GameStop Corp. earlier this year.

Wholesalers pay brokers for the orders, but also offer slightly better trading prices than the brokers would get on exchanges, benefiting investors. Citadel Securities, the largest wholesaler, said it provided individual investors with nearly $1.1 billion in such “price improvement” on equities and options trades in the first quarter. The firm recently floated proposals that could help exchanges win back a greater share of volume that is currently executed on less-transparent venues.

The SEC has long allowed payment for order ﬂow, considering it beneﬁcial for investors, and its use coincides with a drop in retail trading costs.

Payment for order flow can offer less transparency than exchange trading, and its importance becomes even more apparent during bouts of extreme volatility. During one day at the peak of the GameStop frenzy in January, Citadel Securities executed 7.4 billion shares on behalf of individual investors—more than the average daily volume of the entire U.S. stock market in 2019. On some recent days, more than 50% of equities trading volume has taken place outside of public stock exchanges. That threshold was crossed for the first time in December, largely because of the growing role of retail wholesalers.

Some have said payment for order flow poses conflicts of interest for brokerages such as Robinhood, whose revenue from selling orders is partially offset by how much price improvement goes to their customers. That means they can either choose more revenue for themselves or better prices for their customers’ stock trades.

The SEC typically addresses conflicts of interest by requiring clear disclosure about potential problems. Retail brokerages already report how much money they earn from payment for order flow. Robinhood reported $331 million in revenue from the practice in the first quarter of 2021, more than triple the level from a year earlier.

Mr. Gensler said Friday on CNBC that “disclosure alone may not do it.” Some NEWSLETTER SIGN-UP countries, such as Canada and the United Markets Kingdom, ban payment for order ﬂow, he added.

A pre-markets primer packed with news, To address the conﬂict of interest, the regulator trends and ideas. Plus, up-to-the-minute could require brokerages to pass the payments market data. they receive from wholesalers to their customers, said Mr. Harris, who is on the board of Interactive Brokers Group Inc. Alternatively, PREVIEW SUBSCRIBE banning the payments would force wholesalers to compete for orders through oﬀering more price improvement, he added.

Mr. Gensler has suggested that lack of competition might hamper how payment for order ﬂow works. Citadel Securities executes 47% of all retail trades in listed securities, while Virtu has about 25% to 30% of that market share.

“We are going to take a close look at how the market structure can work best, be most eﬃcient and protect investors,” Mr. Gensler said on CNBC on Friday.

Citadel Securities was a beneﬁciary of Mr. Gensler’s regulatory moves when he served as chairman of the Commodity Futures Trading Commission from 2009 to 2014. At the CFTC, Mr. Gensler pushed most trading of swaps—derivatives that emulate exposure to assets such as bonds and currencies—onto electronic trading platforms where multiple parties can compete to oﬀer lower prices, instead of having the contracts arranged privately by big banks.

“Competition and transparency is contrasted to darkness and concentration,” Mr. Gensler said Friday. “That is the balancing. Bring transparency and competition into markets—that is good for investors, that is good for issuers.”

Write to Dave Michaels at [email protected] and Alexander Osipovich at [email protected]

PAYMENT FOR ORDER FLOW SCRUTINY

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• GameStop Mania Drives Scrutiny of Payments to Online Brokers

Appeared in the May 10, 2021, print edition as 'Trading Firms Under Scrutiny Citadel, Virtu Face Scrutiny.'