Virtu’s Optionality? Some Good News…

“That which does not kill us makes us stronger.” – Friedrich Nietzsche

“We adore chaos because we love to produce order.” ― M.C. Escher

 

One intangible cost of being the sole US publicly-traded market making firm is the required level of financial and operational transparency – and the investor relations burden – that comes with that status. In this case, that cost may be unusually high because of the relative opacity of the competitors in this sector – what Alphacution typically refers to as the structural alpha zone of its asset management ecosystem map – coupled with the unparalleled use of technology and extraordinary magnitude of wealth generated by that small group of players.

To compound this dynamic, recent dramatic shifts in the landscape for retail order flow sparked by the late 2019 moves – en masse – to $zero commissions by retail-oriented brokerage platforms, and the quick follow-on consolidations of TD Ameritrade (by Charles Schwab) and E*Trade (by Morgan Stanley), and given the pandemic-fueled volatility and volumes of the moment, it should come as no surprise that the spray of headlines have notched the Klieg lights on this sector to eleven.

And so, we beg your indulgence on yet another Feed post allocated to our friends at Virtu… (We wouldn’t do it if we didn’t think we had something useful to share.)

Now, in our defense, this fact is a confection made partly of the temporal nature of information flows – with different data items being released in different formats on different dates; partly of our internal scheduling of research and deliverables; and, partly – perhaps most importantly – of the fact that we have sometimes been starkly critical of Virtu’s prospects, using metaphors based on frying pans and fires to punctuate our points…

No, this post is not going there. To the contrary, this one is about some good news, something it should go without saying that we could use right now. Here’s the setup:

About a year ago (prior to the ITG acquisition), we published a piece on the Feed entitled, “Virtu’s, Flow Trader’s Optionality? Not So Much…” that illustrated little or no exposure to options trading (according to 13F filings) and how this was likely to be a competitive disadvantage. The basis for this assessment being that success and growth in options market making yields a multiplicity of positive factors, such as improved inventory, improved strategy capacity, improved computational acumen and signaling, and the potential for improved net profitability (given the expanded range of cross-market and cross-product structural alpha extraction possibilities).

Moreover, the primary competitors (particularly in retail order flow wholesaling) – namely, Citadel Securities, G1 Execution Services (a unit of options powerhouse, Susquehanna International Group, or SIG), and most recently, Two Sigma Securities (an enhanced unit of quant powerhouse, Two Sigma Investments, off the back of their late-2017 acquisition of options market maker, Timber Hill) – all displayed dominance, leadership or focused growth in options market making. And, since we often remind that everything is connected to everything else, success in options market making has become state of the art for success in cash equity, ETF and index futures market making – and vice versa…

Markets have become too competitive; the spreads and cross-product pricing inefficiencies too fleeting to preserve market making profitability and growth in a single or subset of available product classes without also trading in options. And so, at that time, we believed Virtu was at a competitive disadvantage.

Now, as an aside, 13F filings specifically for those firms involved, in whole or in part, in option market making have proven themselves to be sporadically less reliable than those of 13F filers who are not option market makers.  For instance, Morgan Stanley & Co. – the broker-dealer and market making unit of that investment banking and asset management group – who is known to be the top US bank-owned player in options, has not reported a single option position in their 13F reports since Q3 2009! And, Wolverine Trading, a leading Chicago proprietary option player founded in 1994, apparently files its first 13F report in Q2 2016 when we can see from its sole FOCUS report (on Form X-17a-5) that the company was holding over $2 billion in securities in 2001! There are other mysteries in this neck of the woods…

Yes, maybe we haven’t found some missing reports. And, yes, maybe we are misinterpreting the data that we have already found. Or, maybe we aren’t fully up to speed on the nuances of the disclosure rules. But, maybe there are also some real holes in the regulatory / compliance nets that are entrusted to submit, assemble and display that data. We will definitely have more to say about this over time, but this little side rant is additional set up for this:

For the first time, in reporting for Q3 2019, Virtu discloses some new details about its option trading activities, below…

Given our prior hypothesis on the competitive importance of option trading in the context of a leading market making platform, this is good news from Virtu.  And, since the latest 13F reports for Q3 and Q4 2019 do not include reporting for a single (long premium) option position, we are going to assume that these are intraday (as in, flat at the end of the day) trades – as opposed to assuming that there are reporting errors or omissions in the latest 13F disclosures.

There’s more:

We have updated the chart – one of my favorites – from the recent Feed post, “Virtu Financial: Musical Chairs,” to include the components of net trading income for Q4 2019 (below). Here, we can see option trading representing $23.4 million of total NTI of $228.7 million for the quarter.

The additional good news here is that this figure is an all-time high (thereby bringing cumulative options NTI over 24 quarters to $3.6 million). Yes, it’s small and may not move the top line needle for a while, but on any given Sunday, this is a game of inches and we need to give credit where credit is due…

Now, I can’t help but continue to wonder what drives all this exploration and diversification outside of it being driven by the competitive landscape in the core US equities (and ETFs) market making business. And, I can’t think of any other reason but to dilute the dependence on that franchise; an exercise that Virtu’s management team has historically done quite well.

Plus, when we assemble the clues, the picture of that competitive pressure becomes even clearer: Recall the available 10-year history of Virtu’s lineage of payments for order flow (PFOF), below, wherein 2019 represents an all-time high, up 36.8% over 2018, the previous all-time high…

Add to that Virtu’s guidance for January and February 2020, where PFOF is estimated to fall in a range of $28 – 29 million (which is already at the doorstep of last quarter’s all-time high of $30.4 million), we come to a simple pro-rata estimate of PFOF for Q1 2020 of $42.75 million; a significant all-time high for the 41-quarter time series (see below). Of course, given the unprecedented craziness we are living through now in March, Q1 2020 total net trading income will be strong and the extra ding from high PFOF may not matter all that much…

But, given all that’s changed over the past few months, it makes sense that competition for retail order flow could heat up. The figures above support that idea. Meanwhile, the company – via CEO, Doug Cifu – presents a compelling defense of the practice as simply a component of providing overall execution quality to a cadre of some 200 retail brokers. You can listen for yourself from a March 11 discussion with Mr. Cifu hosted by Piper Sandler’s Rich Repetto by dialing into a replay of that call at (855) 859-2056 and entering the passcode #4497579.

One last piece of good news before we go:

In a Form 4 filing from November 2019, it is disclosed that Mr. Cifu buys 20,000 shares of VIRT at an average price of $16.24; a low point with good support. (A prior Form 4 from September 2019 shows a 10,000 share buy at an average of $18.58.) Note that these are discretionary trades unrelated to the ~4 million shares owned as part of a compensation package.

Anyway, I always wondered how these discretionary trades would work out…

Hopefully, the expected success of these trades takes a bit of the sting out of the suspension of the NHL season.

Until next time…

By | 2020-03-12T22:36:47-04:00 March 12th, 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.