When the deal between Virtu Financial and KCG Holdings was announced in March 2017, we offered the following read of the motivations behind the announcement:
Average daily adjusted net trading revenue for Q4-2016 has returned to levels not seen since late 2013 / early 2014. Chances are quite high that persistent low volatility during Q1-2017 has caused these figure to fall back to pre-2013 levels. A situation like that needs a good distraction; something that can change the narrative and allow for lots of financial restructuring and restatements. Voila! Try to take out one of your nearest competitors…
Now, with the deal completed as of July 2017, and Virtu now reporting full year 2017 highlights, we took some time to update and combine our Virtu and KCG models. Here’s what’s notable about this latest update:
- The combined financials show some signs of improvement (or, at least, stabilization), however, the market landscape has continued to deteriorate: Over the 28-year life of CBOE’s volatility index (VIX) – aka the “fear gauge” – 2017 recorded the all-time lowest average volatility. In perhaps the greatest “through-the-looking-glass” type of year in recent history; a year when a US president threatened nuclear war on North Korea (among a long list of other extremes), the VIX recorded an all-time low of 9.14 in November 2017. Generally speaking, this dynamic continued to impact the profitability of market-making; an activity that makes up a majority of combined Virtu-KCG revenue (~88% for 2017). So, due to additive impacts, Virtu’s quarterly reading of adjusted net trading income per employee spiked back close to highs not seen since mid-2015 (from $117k to $259K). However, in the market landscape, average net trading income continued to slide in 2017 (down 24.9%), achieving new lows not seen since the pre-2011 period. See exhibits below.
- There were two large sources of savings in the first 6 months of the combined company: compensation and technology spending. Alphacution estimates that in just the second half of 2017, the former KCG team was gutted by about 540 employees or nearly 60%. This move resulted in savings in compensation expenses of about $203 million. And, due to redundancies in data, connectivity and computational arsenals, communications and data processing costs were reduced by another $208 million in 2017.
- With Virtu’s 10K filing due to be reported sometime in late March, we will likely be able to update this case study with more detail soon.
Lastly, we are well aware that the heyday of high-speed trading is in the rearview mirror – and that few of us are currently paying much attention to this formerly vivid corner of the trading landscape. (Certainly, Michael Lewis is not penning a sequel to Flash Boys.) However, to Alphacution, data about highly automated market-making remains incredibly important not only because it is still incredibly rare – (I mean, how often do we get to see the financial guts of what amounts to a leading proprietary trading firm?) – but because it represents one extreme pole of our framework to estimate technology spending and automation levels for the global asset management universe.
So, while the spotlight and the financial glory and the roster of high Sharpe Ratio firms continues to decline, we will continue to be watching closely for entirely different reasons.
Thanks for paying attention with us…