Citadel Securities, the market-making arm of billionaire hedge-fund manager Ken Griffin, has agreed to pay $22.6 million to settle charges that it misled customers about the way it priced trades, the U.S. Securities and Exchange Commission said on Friday.
The SEC found that between 2007 and 2010, Citadel used two algorithms to execute stock trades on customers’ behalf that gave investors a worse price for their trades, even when Citadel knew better prices existed elsewhere. The SEC penalized Citadel for failing to disclose the use of those algorithms to clients.
“This affected millions of retail orders,” said Stephanie Avakian, the acting director of enforcement at the SEC.
Citadel neither admitted nor denied the findings.
“We take very seriously our obligations to comply fully with all laws and regulations,” Zia Ahmed, a spokesman for Citadel, said in a statement.
Citadel executes approximately 35 percent of the daily trading volume in retail equity shares on U.S. markets, the SEC said. Between 2008 and 2010, the two algorithms handled approximately 2.6 percent of the total number of retail orders handled by Citadel’s algorithmic trading engine, and 0.6 percent of the firm’s overall order flow, the SEC said.
Reuters first reported on Thursday that Citadel was nearing a settlement with the SEC.
Citadel, whose hedge fund manages around $25 billion in assets, agreed to pay $5.2 million in disgorgement of ill-gotten gains and a penalty of $16 million.
SEC rules require U.S. brokers to seek the "best execution reasonably available" on stock orders, a standard meant to ensure that all customers get a favorable price and a swift trade.
Citadel is the latest firm to settle with the SEC over routing practices.
While the SEC has fined other firms over order routing, experts say this appears to be the first time any regulator has waded into one of the most contentious strategies in the high-speed trading world.
The practice, known as latency arbitrage, is generally defined as when a firm exploits the difference between stock prices on a slower public data feed known as a SIP and the numerous faster private data feeds provided at a hefty cost by each exchange.
Some Citadel supporters say that the order does not relate to the strategy. They say the firm did not simultaneously trade into and out of stocks based on information from the private data feeds so its activities do not meet the definition of latency arbitrage.
The SEC did not explicitly reference latency arbitrage in its order, but set out factual findings consistent with it, six sources told Reuters including two individuals familiar with the SEC’s thinking.
“The SEC’s order finds that two algorithms used by Citadel Securities did not internalize retail orders at the best price observed nor sought to obtain the best price in the marketplace,” the SEC said in a news release announcing the settlement. “These algorithms were triggered when they identified differences in the best prices on market feeds, comparing the SIP feeds to the direct feeds from exchanges.”
The SEC said in its findings that Citadel used an algorithm known as “FastFill” that was triggered when it noticed that a stock order was priced more favorably on a faster private data feed. It then executed the order off the slower public data feed, even though that price was less favorable for the client, the SEC said. Experts said these findings were consistent with the practice of latency arbitrage.
“The settlement is an admission (by the SEC) that latency arbitrage exists and there are strategies designed to profit from it,” said Jeff Alexander, a partner at Babelfish Analytics, a firm that analyzes market structure for institutional investors and whose work gives him access to private trading data from large investment firms.
Latency arbitrage is the practice of trading on the difference in prices between fast and slow stock exchange data feeds, which is what the SEC found Citadel did, said former SEC lawyer Ty Gellasch, who now runs Myrtle Makena LLC, a financial consulting firm specializing in market structure.
However, three experts with ties to Citadel told Reuters they concurred with the firm. They said the SEC’s findings did not deal with the practice of latency arbitrage.
“Best execution and latency arbitrage are certainly interesting topics - but that is not what this matter is about,” said former SEC Commissioner Dan Gallagher, who joined Patomak Global Partners, a Washington D.C.-based financial consulting firm, as president in January 2016, three months after leaving the SEC. “The Citadel Securities SEC Order involves disclosures which did not adequately describe how orders were filled. Simple as that.”
Citadel is a Patomak client.
The SEC’s case against Citadel has already raised questions about the SEC’s broader regulatory regime for monitoring trading abuses.
The SEC currently requires firms such as Citadel, that execute retail stock trades on behalf of investors, to report their execution statistics to the SEC to show that they are indeed giving customers the best reasonably available price. But it requires them to report trades only against the data coming over the slower public feed in those reports.
If firms were pricing orders based on slower public feeds, when better prices may exist on faster private feeds, as Citadel was just found to have done, then the SEC’s routine monitoring protocols would be unable to catch them, critics say.
“You can’t have a regulatory environment where you claim to have best-execution standards and then mark the reports off the slow feeds,” said Alexander. “That makes no sense whatsoever.”
SEC spokeswoman Judith Burns declined to comment on the criticisms of its reporting requirements.
(Additional reporting by Sruthi Shankar in Bengaluru; Editing by Lisa Shumaker and Howard Goller)