Here’s an update from the initial post on March 15, 2017…
The first wave of commentary is in, and the consensus seems to be that the unsolicited bid by Virtu for KCG is all “about the little guy.” In other words, this deal is all about the position of a wholesaler relative to retail order flow. Maybe so. There is also some suggestion that these firms are not competitors; that, in fact, they may be complementary. Ok, I guess.
But, widen your interpretation of the situation a bit and consider this: According to the 2016 Virtu 10-K, it is disclosed that, “We make markets by providing quotations to buyers and sellers in more than 12,000 securities and other financial instruments on more than 235 unique exchanges, markets and liquidity pools in 36 countries around the world.” The notable liquidity venues are as follows, (and notice the part about “major private liquidity pools.”)
Since #HFT and narratives about highly-automated trading strategies are crowded topics among capital markets punditry, Alphacution has not followed the nuances close enough to know for sure whether the sponsor of a dark pool gets a legitimate first crack at responding to the order flow before the other participants in the pool. Again, maybe so.
However, we tend to focus on these things called numbers – and less on the words. And, the funny thing about numbers is that when you turn them into pictures, and then apply some experience, the story tends be less complicated and less ambiguous (if not, to us).
Whether this deal is about the little guy or not, the fact is that both of these firms have seen better days. By almost every metric we track in our models, both firms saw across-the-board declines in 2016. Among the most notable of these, both Virtu and KCG suffered declines in the all-important profitability analytic “Average Daily Adjusted Net Trading Revenue” in 2016. In the case of Virtu, rather impressively, it was the first decline of this specific KPI in 6 years (see Exhibit below).
BTW, depending on your assessment of the impact of the sale of their interest in BATS in 2016, KCG’s Global Execution segment – you know, the piece formerly known as Knight Capital that includes all that ripe flow from all those little guys – was down 57.5% on a yoy basis. Just sayin’…
Anyway, try to put yourself in Virtu’s position: We know that there is finite theoretical trading capacity at any point in time (for each region and asset class) that is dependent largely on volume, volatility, and the relative intelligence of each parties’ library of algorithms. However, no matter the market and player dynamics, we also know that for US cash equities, KCG, Citadel, Virtu and a few others represent the vast majority of the spread capture.
Be that as it may, I (still) think Virtu is looking at this situation much more bluntly. Theoretical trading capacity has become increasingly coveted. To date, Virtu has been successful in consuming other traders’ alpha, thereby knocking slower, smaller, less sophisticated, and less well-capitalized players off the field. And, with this highest-frequency trading capacity becoming increasingly concentrated as well, the late-stage moves naturally become less subtle. True to this idea, KCG’s trading capacity has a unique ripcord on it – public stock. No other large player in the space offers this lure.
Here’s the incredibly fascinating thing about two companies that represent extremes of “technical leverage” in the entire global financial services ecosystem: Due to the high levels of automation involved here, the old rules of integration may not apply. (And, since I’ve already stated that I don’t think these cultures will mesh together anyways, it turns out that it may not matter after all.)
In our final exhibit below, Alphacution illustrates the “technical leverage gap” between Virtu and KCG – as measured by the difference between annualized adjusted net trading revenue per employee – at $2.1 million, which is significant.
So, what does this mean? One take from this technical leverage angle is that Virtu believes it can acquire KCG’s theoretical alpha and then capture it with higher production efficiency. Abbreviated translation: Holding market dynamics of volume and volatility constant for the time being, if Virtu converts KCG’s trading operations to the level of productivity of its own trading operations (i.e. – from $650,000 in annual adjusted net trading revenue per employee to $2.76 million) then 2016’s adjusted net trading revenue would increase by nearly $300 million (i.e – from $732 million to $1,028 million) and all while reducing KCG’s headcount by 75% – from 952 to 225 – which would represent savings in compensation and benefits of up to an additional $300 million.
Of course, as you hopefully know, this is a limits assessment that could only happen over time, if ever. And, the condition of holding market and competitive dynamics constant is certainly not in the cards, either. But, for those of you who are still following at home, this production efficiency angle might represent an alternative to estimating variance in company valuations and impacts on earnings. At the very minimum, this is yet another chapter in the incredibly fascinating story of how automation is infiltrating global markets and financial services.