SEC Sues Virtu

By R Tamara de Silva

Did Virtu give its in house trading firm unfettered access to client orders? In a significant development, the United States Securities and Exchange Commission (SEC) disclosed today that it had filed charges against Virtu Americas LLC (VAL) and its parent company, Virtu Financial Inc., collectively referred to as Virtu for false and misleading statements and omissions concerning what protective measures it had to prevent the misuse of sensitive client information. Virtu Financial trades under the ticker symbol: VIRT. It is a registered broker-dealer and one of the largest and most successful high-frequency trading firms (HFTs).

Along with firms like Citadel Securities, Virtu pays brokers for the right to execute customer trades-this is termed the payment-for order model (PFOF)-a model invented by none other than Bernie Madoff. Virtu Financial processes an astonishing 25% of all market orders placed by retail customers. Perhaps the reader will recall that PFOF was the primary revenue stream for the retail trading firm, Robinhood Markets (aka Robinhood app).[i]  Payment for order is embedded in the financial system as trading exchanges themselves pay for order flow in the form of offering rebates for liquidity.

According to the SEC complaint, Virtu and its affiliated entities managed two distinct operations which they claimed were adequately isolated from one another. The first was an order execution service designed for large institutional clients, where Virtu Americas would handle and execute customer orders, generally in exchange for a commission (PFOF model). The second was a proprietary trading operation, where the firm engaged in buying and selling securities for its own profit.

However, the SEC contends that between January 2018 and early April 2019, Virtu Americas inadequately protected a database storing all post-trade details originating from customer orders processed and executed by the company. This sensitive database reportedly included customer identities and other confidential, non-public information.

The material misstatements and representations center, according to the SEC complaint center around Virtu consistently and inaccurately assuring their institutional clients and the general public that VAL employed "information barriers" and "systemic separation between business groups" to protect their clients' Material Nonpublic Information (MNPI). But contrary to these claims, the SEC alleges that VAL did not actually have such protective information barriers in place.

According to the SEC complaint, over a span of 15 months, almost all employees at VAL and its affiliated broker-dealers had access to sensitive details about customer trades, including customer names, securities bought or sold, whether the transaction was a buy or sell, the price at which it was executed, and the volume of the transaction.  This information was accessible through generic login credentials accessible to anyone at VAL.

Virtu would no doubt assert that despite the ability of anyone in its in house trading firm being able to see client order information for 15 months, including large institutional orders, nothing nefarious happened.  This may very well be true.

Keep in mind, large institutional orders can impact price and cause price movements. Knowing that price would be affected, would give a trader (or in this case a proprietary trading firm) a huge informational advantage over everyone else. This would in theory permit, activities like front-running and trading ahead. Given that the customer orders are executed in as little as nanoseconds, the ability to profit from seeing large orders would be akin to legalized cheating. HFTs originally came into being to exploit every possible advantage in terms of speed and co-location near a trading exchange’s order matching system so that they could be first to discern and act on price information.

No criminal charges have been filed by the Department of Justice. The practice of PFOF is now firmly entrenched in the financial system and it is unlikely to change despite SEC Chairman Gary Gensler criticizing the practice a few years ago. Though this is a civil complaint and likely to be settled with the payment of a fine, it is an interesting reminder of what may go wrong with one of Wall Street’s arguably more significant and entrenched conflicts of interest.

R Tamara de Silva

September 12, 2023