Insights & Commentary

Market Structure

Market Structure in the News: Market Making Merger

Apr 21 2017

Desk commentary by Jennifer Hadiaris

Market making merger looks to combat challenging market conditions… and other recent market structure headlines

In this note

  • Direct access to customer order flow – both retail and institutional – could increase the efficiency of Virtu’s market making operations and seems to be a key driver behind the KCG merger.
  • The access fee pilot, which will test changes to the maker-taker models on exchanges, seems to be moving forward at the SEC with the strong support of acting Chair Piwowar.
  • Despite recent support from some institutional investors, brokers, and market makers, the push to amend or review Reg NMS Rule 611, the trade-through rule that protects top-of-book quotes, seems to have bumped up against some industry and regulatory resistance.
  • A retrospective review of equity markets by the Financial Times shows the challenges facing active managers, the rise of automated and systematic strategies, and the impact this has had on trading – including intraday volumes and fleeting quotes.
  • Recently the SEC voted unanimously to shorten the settlement timeframe for stocks, bonds, ETFs and other securities to T+2 days. The change will take effect on September 5th, 2017.

Virtu to Handle One-Fifth of US Equity Trades After KCG Deal

Financial Times, April 20, 2017 | Click here for article


  • Virtu Financial has agreed a deal to buy rival market making firm KCG Holdings for about $1.4 billion, which will make the firm one of the biggest participants in the US equity market.
  • Virtu will pay $20 a share in cash, at the top end of an unsolicited $18-$20 a share range it offered in March.
  • After the deal, about one trade in five on the US equity market is likely to pass through Virtu’s systems, putting it on a par with Citadel Securities.
  • KCG is one of the largest players in wholesale trading where companies execute trades for retail houses such as Charles Schwab and TD Ameritrade. In the past, Virtu has noted that they do not participate in payment for order flow relationships.

Our Take:

We had written in a recent note about the headwinds facing the automated market making industry – particularly lower volatility and lower volumes in recent years. Since going public in 2015, Virtu has noted the historically low levels of volatility in the U.S. equity markets in their earnings reports. However, they have been able to somewhat “ride out the storm” given their scale and diversity (trading across multiple countries and multiple asset classes).

That may help answer the question as to why Virtu is looking to make an acquisition now, but many clients have asked why they specifically focused on KCG? There are a few reasons. First and foremost, KCG’s access to retail flow is a valuable proposition for any market maker. KCG is a leader in the “payment for order flow” or wholesaling model, where market makers execute trades on behalf of retail firms. These lucrative trading agreements are part of what made the firm so attractive to Getco back in 2012, following a $440 million trading error at Knight. Diversifying into retail market making – a business that Virtu had previously not had a stake in – would likely prove profitable for Virtu. KCG also has an established institutional business, an area that Virtu seems to have been dipping their toes into in recent years, as they began providing routing and execution services to some institutional trading desks.

Currently Virtu doesn’t have a great deal of direct access to client flow – retail or institutional. As it stands they are largely participating as a market maker in external venues. Many of their market making competitors, by comparison, directly access client flow via retail wholesaling, providing actionable IOI feeds directly to brokers, offering routing services to brokers that will internalize order flow before routing it out to the street, and servicing institutional clients directly. This means that Virtu’s competitors, in many cases, have a “first look” at a decent share of orders before they are sent to external markets – including exchanges and dark pools. Getting access to order flow earlier in its life cycle, with the addition of KCG’s business lines, would likely lead to more informed market making at the combined firm, which would likely improve profitability of Virtu’s market making efforts. Doug Cifu, Virtu’s CEO, acknowledged their current competitive disadvantage when it comes to client order flow, stating, “That’s about a third of the market that we did not have access to. Without the benefit of any customer order flow, we have just been fighting in the shark pit.”

Another impetus behind the merger may be to increase the efficiency and profitability of the combined firm’s market making units. For many years, Knight (and now KCG) has provided a measurement of their market making unit’s profitability per dollar traded in their earnings reports. In recent years – even following the merger with Getco – this profitability measure has declined steadily (see below). This is likely a result of the dampened volatility and volumes over the past several years. However, it highlights the importance of scale in an environment where margins are decreasing.

Market making firms have faced increasing fixed costs across most markets – particularly looking at market data and technology costs. In 2016, communications and data processing expenses at Virtu increased by 3.5% versus the prior year. That is despite a decline in net trading income of 17.3% over the same time period. These are largely fixed costs – including market data charges and connectivity fees at exchanges. Scale allows market makers to defray some of these costs over a larger share of business. As the article above highlights, Virtu and KCG combined will likely handle over a fifth of all US equity market trades. Despite diversifying into other asset classes and geographies, Americas equities still made up over 30% of Virtu’s total revenues in 2016. Scaling and improving profitability within the U.S. equities markets will be highly impactful for the firm as a whole.

With direct access to customer order flow following the merger, Virtu will likely be able to make more informed markets and increase the profitability of their market making activities. They will also likely increase the overall efficiency of the combined firm’s market making activities by accomplishing greater scale – defraying rising fixed costs over a larger business. This comes at a time when the market making industry as a whole has faced a persistently challenging market environment. When we look at all these factors, it becomes easier to see why Virtu would be looking to make an acquisition at this time, and why KCG was their ultimate choice.

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