Stranded, As Virtu Bids Farewell to Madison Tyler

“We don’t receive wisdom; we must discover it for ourselves after a journey that no one can take for us.” – Marcel Proust

With pandemic-era factors being historically and paradoxically hospitable for market volumes and volatility, those players that stand in closest proximity to the sources of listed liquidity have experienced an unexpected windfall so far in 2020. Today, with market making revenue for the past two consecutive quarters at all-time highs and seeming to bend a long-term downward trend in a new upward direction, VIRT stock found its own all-time high…

For the remainder of this story, we need to refresh your perspective with a little context: Founded in 2008, Virtu is the youngest of a dozen leading proprietary trading and market making firms in the world:

What is most unique about Virtu, however, in the context of this group is that it has grown primarily by acquiring other people’s trading strategies – typically by outright acquisition of other companies – from the beginning. By comparison, all the others on this roster have grown their core trading strategies much more organically.

Admittedly, all of these firms compete – and sometimes may try to poach – for top talent; and, more recently, have resorted to corporate type acquisitions of their own. (See, for example: SIG/G1X, DRW/RGM, DRW/Chopper, TSI/Timber Hill, and HRT/Sun.) In most cases, these moves have been capacity-expanding additions to mature, internally-developed core strategies. This progression is not the case for Virtu…

Many folks, including the most astute insiders, don’t realize – or remember – that Virtu started as Madison Tyler Holdings, LLC (with their regulatory disclosures further disguised as EWT, LLC). In preparation for their IPO, Madison became Virtu Financial BD, LLC and assumed regulatory disclosure requirements by Q2 2012:

Now, let’s try to ignore the bizarre and currently unexplainable fact that – as of the writing of this Feed post – Virtu has not filed its Q1 2020 13F-HR report (expected in May) and move straight to what shows up in the Q2 2020 13F-HR report: Virtu Financial BD, LLC (VFBD) has been reduced to a single position while Virtu Americas, LLC (which, coming online after the KCG acquisition in Q3 2017, was formerly known as KCG Americas, LLC; which itself was formerly known as OCTEG, LLC; a unit of our old friends at GETCO) is holding everything else…

Virtu Americas is also a leading participant in payment for order flow (PFOF) behind Citadel Securities and Susquehanna International Group (SIG) units, G1 Execution Services (G1X) and Global Execution Brokers (GEB). The VFBD strategy was never designed to rely on PFOF…

In other words, it appears that – since year-end 2019 – Virtu has consolidated its core market making strategy to that of the grandchild of GETCO. Here are some clues of that strategy shift:

Here, we can see that Virtu’s core strategy is no longer dependent on (futures) index arbitrage, where the profitability of futures and cash equities are inversely correlated (see Q1 2018, above). Instead, the Virtu Americas strategy – let’s call it a turbocharged version of GETCO’s strategy – is much more heavily dependent on the arbitrage between liquid ETFs and the components of those ETFs being cherry-picked via specific PFOF arrangements with one or more retail brokers, and where the spread between implied and realized volatility is likely no longer having the same impact on profitability (see Q1 and Q2 2020, above – and below).

NOTE: What if we find out that Robinhood (and/or others) are promoting the names that fit nicely against such a strategy? Think about it. Most of the revenue here is no longer coming from customers. It’s coming from market makers…

Now, there are some other clues – uh, more like corporate body language – that suggest these kinds of dependencies (and folks like us shining our light on it) make Virtu management nervous. After all, they’ve already stopped reporting headcount since we pointed out how skilled they were at decapitation after the KCG and ITG acquisitions.

So, as of Q2 2020, Virtu is no longer reporting PFOF as a separate line item in their income statement. PFOF has now been comingled with brokerage, clearing and exchange fees, which – frankly – makes some sense, since it’s a cost of trading. It also seems a little silly to hide PFOF when it is being reported (in disaggregated form) in the 606 reports of retail brokerage counterparties.

Anyway, Alphacution’s Q2 2020 PFOF estimate for Virtu of $101 million represents a 328% increase over Q2 2019 – a very long time ago in the pre-zero-commission era – and a 62% increase over Q1 2020:

One last thing:

“As a leading global market maker, Virtu generates deep liquidity that helps to create more efficient markets around the world. We combine our market structure expertise and execution technology to provide competitive bids and offers in over 25,000 securities, at over 235 venues, in 37 countries worldwide.”

Virtu Website

Statements like this have been floating around Virtu collateral since the S-1, and our ongoing analysis has always kept me wondering:

Do the charts below showcase a company generating deep liquidity, providing competitive bids and offers in over 25,000 securities, at over 235 venues, in 37 countries worldwide” – or do they showcase something else?

Bottom line: A company that has been so dependent upon growth by acquisition (and profitability by “headcount efficiencies”) has limited internal research and development capabilities by default. Today, Virtu is trying a lot of things – and issuing a lot of press releases – but the prior fact limits those fruits in such an intensely competitive environment where a small subset of those competitors can trade across products, asset classes, regions and styles in ways that Virtu simply can’t – and likely never will…

In fact, Virtu is stranded on an island made of US cash equity products; an island that requires more “resources” (PFOF) to hunt for “food” (spread / trading profits) while at the mercy of the “weather” (volume / volatility). A major problem here is the impact this dynamic is having on the neighboring ecosystem no matter the outcome.

If Virtu continues to thrive, as they have done particularly over the first half of 2020, then it will continue to do so at the expense of novice retail investors (and the rotting of the broader society with their addiction to frictionless and highly gamified distractions). If Virtu stumbles, it could leave a critical segment of our distorted market ecosystem more insanely concentrated than it already is.

Food for thought.

Not expecting anything proactive to be done about it.

Pass the popcorn.

Until next time…

By | 2020-09-10T01:04:55-04:00 September 9th, 2020|Alphacution Feed|

About the Author:

Paul Rowady is the Director of Research for Alphacution Research Conservatory, a research and strategic advisory platform uniquely focused on modeling and benchmarking the impacts of technology on global financial markets and the businesses of trading, asset management and banking. He is a 30-year veteran of the proprietary, quantitative and derivatives trading arenas. Contact: feedback@alphacution.com; Follow: @alphacution.