There’s a scheduled court hearing on October 25th 2021 between plaintiff Citadel LLC and the US Securities and Exchange Commission (SEC) at the United States Court of Appeals for the District of Columbia Circuit.
This case was filed by Citadel securities suing the SEC for implementing a new stock order type called D-Limit; A way to give traders a way to buy and sell stocks at the IEX while shielding them against volatile/manipulative price moves.
On accessing the court document available to the public, it was clear that the SEC felt that market makers like Citadel Securities enjoy unfair advantages over other market participants.
What happens when you place a Buy/Sell order
Sixteen public stock exchanges are operating in the United States, and IEX (one of the stock exchanges’) was founded in 2012 (later became public in 2016) to mitigate the risks of high-speed trading.
When an investor places an order to buy or sell a stock, their brokers have various routing options. They can send orders to one of at least 16 public exchanges, known as “lit” exchanges, because they are the most transparent and highly regulated.
Each of these exchanges publicly displays the current ‘buy’ and ‘sell’ prices for securities, and they send that information to a data feed that is publicly available on a non-discriminatory basis. This pricing data determines what are deemed to be the current “national best bid” and national best offer (collectively the “national best bid/offer”) for any particular stock.
High-frequency trading firms may execute orders against their own inventory, i.e. internalize the orders or route them to a dark pool or exchange. But brokers like ‘Robinhood’ may also choose to send orders to one of at least seven high-frequency trading firms, also known as “internalizers,” such as Citadel. Internalizers are subject to comparatively little regulation.
Brokers can also send orders to one of over 30 “alternative trading systems,” each known as an “ATS” or “dark pool.” Dark pools, as indicated by the name, are less transparent than public, lit exchanges. Their prices are not publicly available and they do not contribute to the public data feed that informs the national best bid/offer. Dark pools are attractive to investors or traders who worry that other traders—high-frequency trading firms in particular—may “pick off” their orders at low prices on lit exchanges.
This could be the reason why securities such as AMC Entertainment (AMC) and GameStop (GME) have more than 60% of their daily trades executed in Dark Pools.
Because of Market fragmentation, there is a slight time delay for the information from the exchanges to reach the data feed and vice versa. The delay is in microseconds and is unavoidable due to the laws of physics. It simply takes time for the data to get transmitted.
This is where High-Frequency Traders (HFTs) can access pricing data faster than the data reflected in the consolidated data feed. Firms like Citadel and a handful of other privileged market participants use high-frequency trading programs (algorithms) that exploit this technical vulnerability and gain profits at the expense of (Retail) traders.
For example, suppose the national best bid, as reflected in the national best bid/offer for a stock, is $10.05, and an order comes into the New York Stock Exchange at $10.06. Eventually, the national best bid/offer will show that the new national “best” bid is $10.06. But, as explained above, there is a delay or a latency between when this bid is entered on the NYSE and when it is actually reflected in the national best bid/offer. Anyone who knows about the order for $10.06 on the NYSE can essentially guarantee themselves a profit during that period of latency by buying the stock at the now stale “best” bid of $10.05 before the price moves up to $10.06 and then selling it once the national best bid/offer is disseminated. This strategy is known as “latency arbitrage.”
This gives an investor/firm the technological capacity to ‘see’ the NYSE price and trade before it even appears in the national best bid/offer.
The Latency Arbitrage strategy is expensive, but it almost guarantees profitability. The magnitude of these costs and the willingness to incur them suggests the enormous profitability of the firm.
Companies like Citadel are not public, and their revenue streams/sources are not transparent. In 2015, Citadel Securities was barred from trading in China for “malicious short-selling” and use automated trading systems. This was settled on January 1st, 2020.
Latency Arbitrage practices motivate many sophisticated investors such as pension funds to take their trades elsewhere, typically to a dark pool where they are less likely to suffer the predations of the high-frequency traders. As a result, lit exchanges lose volume, liquidity, and price transparency.
What is D-Limit?
To tackle this vulnerability, the IEX group proposed introducing ‘speed bump’ and Crumbling Quote Indicator (CQI), together addressing latency arbitrage by creating a period in which IEX can reprice stale orders high-frequency trading firms can seize on them. This repriced type of order is called Discretionary Limit order or D-Limit order.
A ‘Speed Bump’ is a 38-mile coil of wire (in length) through which messages to IEX must travel. Passing through this 38-mile coil adds about 350 microseconds to the time it takes for a message to reach IEX.
Crumbling Quote Indicator (CQI), using a proprietary formula developed by IEX, predicts when the national best bid/offer in a particular stock is unstable and may soon be shifting up or down. In simple terms, this is basically exchange created AI versus the AI used by the traders using latency arbitrage strategies.
This protects retail traders against pump and dump schemes, artificial volatility by manipulation and stops high-frequency traders from picking off-limit orders. IEX group argues that this new order type will level the playing field for the little guys. In August 2020, the SEC approved using this D-Limit order type created by the IEX group.
Citadel securities suing the SEC
This new order type might sound fair to an average trader but not to one of the leading global market makers’ – Citadel Securities. Citadel filed a lawsuit in late 2020 against the SEC for approving this new order type. “The SEC failed to properly consider the costs and burdens imposed by this proposal that will undermine the reliability of our markets and harm tens of millions of retail investors,” a Citadel Securities spokeswoman said in an email.
This is where things become contradictory. The primary purpose of implementing the D-Limit order type was to promote price discovery and liquidity while protecting investors (predominantly retail) from unfair activities of HFT. It also will encourage institutional traders to execute their orders in ‘lit’ exchanges rather than in dark pools.
And Citadel’s argument against this is that D-Limit will harm retail investors. Citadel hasn’t given any valid explanation on how D-limit order type will harm retail traders. The SEC squashed various speculative arguments presented by Citadel before approving the D-Limit order type.
The Bottom Line:
The entire court document was brilliantly summed up in a footnote.
Citadel has a lengthy track record of making arguments that purportedly serve investors’ interests, only to be proven wrong. For example, Citadel argued strenuously that approval of IEX’s application to be a national security exchange, with its speed bump, would harm investors. E.g. Citadel Letter regarding IEX’s Application to Become a National Exchange – proven wrong. Similarly, Citadel vigorously opposed approval of the D-Peg P-Peg order types, which are similarly designed to protect investors. And yet, as investors urged, these order types were approved and are widely used to beneficial effects.
IEX President Ronan Ryan, in a statement quoted by the Wall Street Journal, said he was confident the SEC’s decision will be upheld. “Since its launch on October 1st, D-Limit is already proving valuable to a broad set of market participants,” Ryan said.
The SEC is closing in on Citadel. Being a high-frequency trading firm, Citadel relies on superior speed, access, and information that blatantly provides them with an unfair advantage over the other investors, and the D-Limit order type is levelling the playing field. On the other hand, the SEC is considering completely banning Payment For Order Flow (PFOF), Citadel’s two primary revenue sources.