As an individual investor, you may not know much about the inner workings of the stock market. Or care.
But it's starting to dawn on novice traders in GameStop and other gyrating stocks that what you don't know can cost you.
Many investors who've flocked to the Robinhood stock trading app to buy and sell shares in recent months, for example, almost certainly didn't know they were customers of a powerful, behind-the-scenes trading firm called Citadel Securities, founded by Chicago billionaire Ken Griffin, a middleman or "market maker" who actually executes their trades.
These investors were probably also unaware that as Robinhood and Citadel have grown, regulators found they didn't always give customers the best prices on their securities trades. Both have had past run-ins with regulators.
Now, however, the losses individual investors absorbed during GameStop mania have drawn the interest of federal law enforcement officials, the Wall Street Journal has reported and NBC News has confirmed, nosing around to see if any laws or rules were broken.
On Thursday morning, Congress is set to address the matter in hearings convened by Maxine Waters, the California Democrat who chairs the House Financial Services Committee. Among those on tap to testify is Citadel's Griffin, whose mighty firm executes huge swaths of trades for Robinhood and other brokers daily.
At stake is a simple question: Is the operation of the U.S. stock market, with its many complexities, fair to individual investors? At least one of the practices from which Citadel benefits is forbidden in some countries.
"At the end of the day this is about whether or not your broker is getting you the best prices or trying to maximize their own profits," said Tyler Gellasch, executive director of the Healthy Markets Association, an investor-focused not-for-profit that works to educate market participants. "If brokers aren't required to give you the best prices, somebody benefits, and often that somebody is Citadel."
Josh Zeitz, a Citadel spokesman, disagreed. "Citadel Securities has been a driving force in reducing the costs of trading for retail investors," Zeitz said in a statement. He said retail brokers use Citadel because they are obligated to route trade orders to the firm best able to execute them.
A magnet for stock orders
Citadel is the biggest and most powerful company executing stock trades both for its own account and for investors in U.S. equity markets. Since Jan. 2017, volume in U.S. stocks handled by Citadel off any stock exchange has doubled from 7 percent to 15 percent, according to data provided by GTA Babelfish, a trading analytics firm that advises investors on trade executions. During the week of Jan. 4, 2021, Citadel handled more overall trading volume than the Nasdaq stock market, GTA Babelfish data shows.
One reason for this growth: Increasing interest in the stock market among individual investors.
Another: Citadel pays big money to firms like Robinhood, Charles Schwab and TD Ameritrade for the privilege of executing trades for these firms' individual investor customers.
Citadel is a magnet for stock orders and sends increasing "payments for order flow," as they are called, to retail brokers. In the last three months of 2020, for example, regulatory filings show Citadel paid Robinhood $107.8 million to execute a portion of its stock and options orders.
These payments have helped Citadel capture a large percentage of Robinhood's trades. In October, for example, Citadel handled 70 percent of Robinhood's options trades placed at the prevailing market price, the filings show, with the next largest "market maker" handling 15 percent.
Robinhood receives higher payments on securities that carry wider spreads, that is, the difference between what an investor pays to buy and what he receives in a sale. Robinhood says it sends its orders to the market maker most likely to give the customer the best execution.
In December, Robinhood paid $65 million to settle an SEC enforcement action for not disclosing how much money it was receiving for routing its orders to firms like Citadel and for failing to seek the best price for its customers' orders. Robinhood neither admitted nor denied the allegations.
"Due in large part to its unusually high payment for order flow rates," the SEC said in announcing the settlement, "Robinhood customers' orders were executed at prices that were inferior to other brokers' prices." This failure deprived its clients of $34.1 million, the SEC said.
A Robinhood spokesman provided this statement: "The settlement relates to historical practices that do not reflect Robinhood today. We are fully transparent in our communications with customers about our current revenue streams, have significantly improved our best execution processes, and have established relationships with additional market makers to improve execution quality."
Long before this settlement, though, payment for order flow had been criticized by investor advocates as potentially harmful to investors. The harm can arise because investors' trades that go to a market maker that paid for them are more likely to be kept inside that firm, a practice known as internalization. If kept under wraps, those trades won't wind up on venues, like an exchange, where they would be exposed to other buyers or sellers, maybe resulting in a better outcome for investors.
This makes sense if you think about stock trading as an eBay transaction. Say you'd like to list a bicycle for sale on eBay at $100, a price you think is reasonable. Unknown to you, however, a buyer is willing to pay $110 for it. You learn about this interest when eBay displays your offer and a buyer steps up at a higher price. If eBay had not displayed your offer and simply paid you the $100 you were asking, you'd have never learned that another buyer was willing to pay $10 more.
Payments for order flow are banned in other countries' stock markets, including those in the United Kingdom, Australia and Canada. In a 2019 report on the practice, the Financial Conduct Authority, Britain's regulator, said such payments make it "more likely that extra costs will be passed on to the broker's client" and "may lead to poorer outcomes for clients and reduce market integrity."
Market makers like Citadel say paying for orders is not a problem because they deliver big savings to investors by giving them better prices on their trades. "Last year alone, we provided $3 billion in price improvement that went directly into the pockets of retail investors," the Citadel spokesman told NBC News.
But critics say figures like these can't be compared to the investor savings that would result from broader access to Robinhood's and other brokers' customer trades.
"$3 billion sounds like a large number, but it has no context and there's no opportunity to do a comparison," said Jeff Alexander, cofounder of GTA Babelfish. "Saying the Yankees scored 6 runs sounds great, until you find out that the Red Sox scored 8."
Gellasch agrees, saying that market makers' definition of "price improvement" bears little relation to whether a customer received the best available price. Market makers can claim to provide price improvement, he told NBC News, even if they are "providing prices that are significantly inferior to those that may be available in the marketplace."
Market makers like Citadel make money by pocketing the difference between the price at which they buy shares — the bid — and the price they receive from selling them to Robinhood clients, the offer. Other firms in the business are Virtu Americas, G1X Execution Services and Two Sigma Securities.
Brokers have a duty to ensure their customers receive "best execution" regarding prices on trades. But as Gellasch noted, it is very difficult for individual investors to know if they are getting the best prices.
In 2017, the SEC brought an enforcement case against Citadel, contending that even though the firm had promised to provide customers with the best prices, either by executing the trades internally or on other venues, Citadel had two execution strategies that did not do that. Millions of trades were affected, the SEC said. Citadel paid $22.5 million to settle the matter, without admitting or denying the allegations.
Even though Citadel now pays hundreds of millions for other firms' retail stock and option orders, the firm used to criticize the practice. In an April 2004 letter to the SEC, Citadel's general counsel, Adam Cooper, urged the regulator to ban the practice in the options markets.
"In practice, the conflict of interest caused by payment for order flow may lead broker-dealers to execute customer options orders at a 'defensible' price, rather than aggressively pursuing the best possible price and seeking price improvement opportunities," Cooper wrote.
Just over a year after Cooper's letter, Citadel Execution Services, the unit that pays for orders, started operating.
According to a person familiar with the firm's change in thinking, payments for order flow have become a feature of current market structure and are well-regulated.
'Which way the market is going'
The types of orders Citadel pays for — those of individual investors — are far more profitable and less risky than orders from big institutional investors. That's because individual orders are typically small and easily filled in their entirety, while institutional investors with thousands of shares to transact must parcel them out their bit by bit to avoid disrupting the market in a stock.
When a firm like Citadel executes orders, it also receives valuable information on the direction a stock is likely to take. Market maker firms handling flow get to see unfilled orders from customers at specified prices the market hasn't hit yet.
These include a type of sell order known as a “stop-loss” that’s triggered at a price below the prevailing market. Such orders are designed to limit investors’ losses.
Knowing how many stop loss orders are awaiting execution, and at what prices, signals where the floor is in a stock. It's information any professional trader would covet.
"If somebody is willing to pay you for the order flow it must be valuable," said Joe Saluzzi, partner and cofounder of Themis Trading, an independent firm that executes trades on behalf of institutional investors. "It's not trade by trade that matters, it's the aggregate of them all that allows you to figure out which way the market is going."
The Citadel spokesman said, "The firm states in its client disclosures that it does not use unexecuted stop-order information to inform its trading."
As the biggest market maker in the U.S., Citadel Securities has a bird's-eye view on many stocks, as well as the overall market. Citadel data showed it handled 29 percent of trading volume in GameStop the week the stock crashed.
Citadel is a power player in other stocks adored by individual investors. According to Babelfish data, during the first week of January, Citadel executed 25 percent of trades in AMC, the theatre chain, 17 percent of trades in Apple Computer and 16.3 percent in Tesla.
As Citadel and the handful of other market makers have come to dominate stock trading in recent years, investors' execution costs have rocketed. This shows up in a stock's spread, the difference between the bid and the offer.
In 2012, that difference averaged around 2.5 cents in S&P 500 stocks, according to Bank of America data. In late 2019, it was more than double that. When spreads widen, market makers' profits increase and investors pay more.
The GameStop imbroglio is not the first time market makers have come under scrutiny from law enforcement. In 1996, the Department of Justice settled an investigation into major Nasdaq market makers that found the firms had conspired to set bid and offer prices of stocks they traded at levels that generated high profits to themselves but raised investors’ costs.
From 2009 to 2020, the Financial Regulatory Authority has brought 18 enforcement matters against Citadel Securities, FINRA records show. Citadel settled all without admitting or denying the regulator's findings. FINRA cases against Citadel Securities are more numerous than those against each of its primary competitors during the same period.
One case involved Citadel trading ahead of its customers, a regulatory violation. Firms are supposed to execute their customers' orders first to ensure they get the best price. Citadel paid $700,000 to settle the matter. From September 2012 through mid-September 2014, FINRA said, Citadel Securities removed hundreds of thousands of its customers' over-the-counter stock orders from immediate execution. While the trades sat unexecuted, Citadel "in many instances" traded for its own account.
In another, Citadel paid $239,000 to settle a FINRA case alleging that in 2007 and 2008 it had not made a sufficient effort to get the most favorable price for its customers in more than 1,500 transactions.
The Citadel spokesman declined to comment on these cases.