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 The Justice Department has subpoenaed information from Citadel and
KCG <KCG.N> related to the firms' execution of stock trades on
behalf of clients, according to people familiar with the
investigation.
Authorities are examining internal data concerning the firms’
routing of customer stock orders through exchanges and other trading
systems, to see whether they are giving customers unfavorable prices
on trades in order to capture more profit on the transactions,
according to the people familiar with the inquiry. Under Securities
and Exchange Commission rules, U.S. brokers are legally required to
seek the “best execution reasonably available” on orders, a standard
meant to ensure that all customers get a favorable price and a swift
trade.
The Justice Department has looked at a number of high-speed trading
firms that pay retail brokerages to sell them their flow of customer
orders for stock trades. This segment of the industry is known as
wholesale market making.
 The documents subpoenaed from KCG related to the firm’s market
making activities from 2009 to 2011, according to a person familiar
with the KCG probe. In 2012, the head of KCG’s electronic trading
group, which included its wholesale market making arm, Jamil
Nazarali, left the firm to join Citadel. Since then, Citadel’s own
wholesale market maker has grown substantially under Nazarali.
The inquiry is being driven by Justice Department authorities who
previously investigated banks for alleged wrongdoing in the market
for residential mortgage-backed securities, these people said.
Making those cases, which yielded billions of dollars in penalties,
required investigators to master some of finance’s most complex
markets. The current undertaking presents similar technical
challenges.
It isn’t clear what sort of evidence the federal investigators may
have compiled in their inquiries. And it is possible that no cases
will result from the investigations.
A spokesman for KCG declined to comment, as did a Justice Department
spokesman. In an August 2015 filing with the SEC, KCG disclosed the
existence of a Justice Department probe but provided no details.
A spokeswoman for Citadel said she could neither confirm nor deny
the firm’s involvement in the investigations, but said Citadel
cooperates fully with any requests from enforcement agencies.
“As one of the largest market-makers and providers of liquidity in
the U.S., we regularly receive inquiries from and work closely with
a number of regulators and others regarding our business and market
practices,” said Katie Spring, a spokeswoman for Citadel. “We
cooperate fully with such requests, but as a matter of practice, we
simply don’t confirm any particular inquiry.”
 THE HIGH-SPEED DEBATE
One person familiar with the inquiry said that based on the tenor of
the discussions with investigators, Citadel expects the probe will
conclude with no action recommended.
If authorities do move ahead, they would be marching forcefully into
the debate over high-speed trading. Critics have alleged that firms
with the fastest trading technology are using speed to manipulate
stock prices, giving investors a raw deal. The industry counters
that its technology delivers cheaper and more transparent trades to
investors.
The Justice Department inquiry is the latest example of increased
scrutiny on speed traders since the "flash crash" of 2010, when
markets suddenly plunged and quickly rebounded. A study commissioned
by U.S. regulators later found that high-speed trading contributed
to the crash.
Citadel and KCG are among several firms being examined in a separate
probe by the New York State Attorney General. New York authorities
are examining firms that buy and sell the flow of trading orders
placed by investors, according to a person familiar with that
investigation. The authorities are also looking at other practices
in the world of high-speed stock trading that may disadvantage
retail investors. Citadel and KCG declined to comment on that
inquiry.
The New York State Attorney General recently reached settlements
with Barclays <BARC.L> and Credit Suisse <MLPN.P> after finding that
the two banks were making inadequate disclosures related to
high-frequency trading in their private stock-trading venues, known
as dark pools.
Citadel is led by one of Wall Street’s most powerful billionaires.
Founder and chief executive Ken Griffin topped Forbes magazine's
2016 list of the highest-earning hedge fund managers, making $1.7
billion in 2015 alone, according to Forbes. In February, Griffin
made headlines with what is believed to be the largest private art
purchase ever, paying $500 million for two paintings by Willem de
Kooning and Jackson Pollock.
Citadel is best known for the consistently market-beating returns of
its $23 billion hedge fund. But for years, the firm also has been in
the vanguard of creating alternative electronic markets for trading
stocks and other financial assets.
 Citadel’s own private stock-trading platform is so large that, if it
were an official exchange recognized by the Securities and Exchange
Commission, it would one of the largest registered exchanges in the
United States - bigger than Nasdaq Inc, according to data published
last month by the Financial Industry Regulatory Authority. Citadel
Execution Services, the firm’s wholesale market-making unit,
executes 35 percent of all trades by retail investors in U.S.-listed
stocks, according to the firm.
KCG was formed in December 2012 from the merger of New Jersey-based
Knight Capital Group and Chicago-based high-frequency-trading firm
Getco LLC. Knight was forced into the merger after an August 2012
computer trading glitch led to millions of accidental stock orders
flooding the market in less than an hour, leaving the firm with a
$468 million loss.
PAYING FOR ORDER FLOW
Established in 1995, Knight was a pioneer of electronic market
making. It has had previous run-ins with authorities over its
handling of customer trades. In 2002, Knight paid $1.5 million to
settle regulatory charges related to its market-making operations.
In 2004, Knight paid $79 million to settle SEC allegations that it
had overcharged customers.
Today, KCG is second only to Citadel in the market for handling
stock order flow from retail brokerage firms.
KCG and many other high-frequency trading firms have shied away from
the public spotlight. KCG, for example, has appeared to pivot away
from some of the market-making activities now coming under scrutiny.
In February, KCG sold its market-making seats on the floor of the
New York Stock Exchange to Citadel.
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Citadel has taken a higher profile. Last year, it set off a price
war with rivals that enabled it to expand its share of the
market-making business. Citadel also has argued vocally in the
media, and to regulators, that its wholesaling operation is good for
investors. The head of Citadel Execution Services, Nazarali, secured
a seat last year on the SEC's new Equity Markets Structure Advisory
Committee, where he has cast himself as a spokesperson for the
interests of retail investors.
The Justice Department inquiry appears aimed at a pillar of the
market’s structure: the strategy whereby market-making wholesalers
such as Citadel pay retail brokerages for their clients’ order flow.
The practice of paying for order flow, per se, is legal. But it also
has been controversial, going back to the days of disgraced Wall
Street investment manager Bernard Madoff, who pioneered the practice
of buying client trades.
Critics contend that practice poses a potential conflict of interest
for retail brokerage firms: They may be tempted to sell customer
orders to the highest bidder rather than to the market maker who
will obtain the best prices and fastest execution for investors. A
related question has dogged the market makers: Why are firms willing
to pay for stock orders if they are in turn executing those trades
at the best available prices?
Small, day-trading investors make up the majority of the customers
of mass-market brokerage firms such as TD Ameritrade, Charles Schwab
and E*Trade. These firms sell their stream of stock-trading orders
to market makers such as Citadel and KCG.
ATTRACTIVE CUSTOMERS
The market makers find the small trades attractive, because they are
less likely to move the market than the massive trades made by big
institutional investors. Handling high volumes of small trades
allows firms like KCG and Citadel to make reliable profits. The
market makers collect the "spread" between the price paid by a buyer
and reaped by a seller, while still vowing to give customers
comparatively advantageous prices.
TD Ameritrade spokeswoman Kim Hillyer said the firm does not comment
on regulatory actions. A spokeswoman for E*Trade said the firm
ensures that clients get the best possible execution of stock orders
by conducting regular internal and external reviews. A Schwab
spokesman said Schwab routes orders to wholesalers based solely on
which one gets customers the best prices.
Citadel points to statistics showing that the average price paid by
investors on most stock trades has declined steadily in recent
years, as high-speed firms such as itself have assumed a greater
role in market-making on electronic exchanges. Critics say these
statistics might not tell the whole story. Most of these statistics
are based on a relatively slow data feed that lists current stock
prices, critics say. Market-maker firms have access to numerous
faster data feeds showing more up-to-date prices.
Investigators believe this information gap means that a firm could
claim it got the optimal deal for a client based on the prices on
the slower data feed, even as the firm knew a better price existed
on a faster feed. Securities lawyers say this could constitute a
breach of a firm’s legal obligations. In December, the U.S.
Financial Industry Regulatory Authority warned firms against the
practice.
CRUCIAL MILLISECONDS
Justice Department investigators seem interested in what Citadel’s
high-speed traders do with a stock order between the instant Citadel
receives that order from a retail brokerage and the moment it
ultimately executes the trade on behalf of a client, according to
people familiar with the probe.
The blink-of-an-eye process usually takes Citadel upwards of 20
milliseconds, or 20 one-thousandths of a second. That’s a long time
in the world of high-frequency trading, however, where it takes
seven milliseconds for a signal to travel between New York and
Chicago.
The Department of Justice is using a statute known as the Financial
Institutions Reform, Recovery and Enforcement Act, or Firrea, to
conduct its probe. Adopted in 1989 during the savings-and-loan
crisis, Firrea was dusted off and redeployed by prosecutors after
the 2008 financial crisis.
The statute empowers the Justice Department to pursue criminal
violations involving banks by pursuing a civil lawsuit, which has a
lower standard of proof, to collect penalties. In contrast to facts
produced by grand jury subpoenas used in a criminal probe, which are
tightly held, information gleaned from a Firrea subpoena can be
shared more freely with other prosecutors and enforcement agencies.
Since 2012, the Justice Department has used the Firrea process to
extract billions of dollars in settlements from banks and other
firms for misconduct in the housing market before the financial
crisis. Firrea charges underpinned most of the government case that
resulted in a $5 billion settlement with Goldman Sachs [GSGSC.UL]
last month, as well as a $25 billion settlement with Bank of America
<BAC.N>, a $13 billion settlement with JP Morgan Chase <JPM.N>, and
a $7 billion settlement with Citigroup <C.N>, all connected to
actions in the packaging and sale of mortgage backed securities.
As regulators have scrutinized the practice of paying for order
flow, some prominent firms have changed their policies. Fidelity
stopped accepting payment for many types of orders from market
makers in early 2015. Schwab last year modified its policies on
order payment to avoid any appearance of impropriety, according to a
firm spokesperson.
Goldman Sachs exited the wholesale market making business altogether
last summer. At the same time, it announced that the firm’s dark
pool was going to stop using the controversial slower data feed and
rely instead solely on faster private market feeds.
Citadel has emerged as a champion of the industry. It has been the
leading voice opposing SEC approval of a new stock exchange, IEX,
owned by a consortium of buy-side investors. IEX plans to institute
a short, 350-millionths-of-a-second delay in the execution of stock
orders, in what it says is an effort to minimize the advantages of
high-speed traders.
Citadel has waged a public campaign to block the new exchange. In
public comments to the SEC, it has argued that the speed delay will
lead to outdated share prices, harming investors.
KCG has stayed quiet on IEX’s proposal.
(Edited by Michael Williams)
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