Virtu Never Loses (Well, Almost Never)08.11.2016 By John D'Antona Editor, Traders Magazine
(This article originally appeared on Bloomberg)
A computerized voice rang out on Virtu Financial’s New York trading floor one Friday morning in late May: “Something’s wrong.” This was the Watcher, an automated program the electronic market-making company created to alert risk managers when any of the millions of orders it places on a given day go awry. In this case, Virtu had entered into a $1 million currency contract but then decided to cancel the order. While it took only 700 microseconds to get confirmation that the trade was on, the cancellation hadn’t been acknowledged by the exchange within 5 seconds, triggering the Watcher’s Stephen Hawking-like voice.
That morning, the Watcher had already flagged another issue on an order at an African stock exchange. A bit later it directed risk managers to investigate two trades on a European energy market. Virtu often trades as many as 5 million times a day. Amid that ocean, it’s built its risk-management systems to catch even these few errant drops of water.
If this precision and attention to detail feels militaristic, that’s because it is. Vincent Viola, who founded Virtu in 2008, graduated from West Point and came of age jumping out of airplanes for the U.S. Army’s 101st Airborne Division, also known as the Screaming Eagles. He named the company Virtu for the Latin word “virtus,” peppers his speech with such terms as duty and mission, and instills in his employees the type of devotion more common on a battlefield than in a boardroom. And like anybody who flings himself from the back of a C-130, Viola values two traits above all: trust and efficiency. “I’ve tried to re-create that in my Wall Street experience,” he says during a rare interview at a Manhattan cafe in June.
Viola’s principles have not only transformed how markets operate in an increasingly computerized era; they’ve also made his company—with its market value of $2.4 billion—part of Wall Street’s new guard, one that’s risen as power and profit have shifted away from traditional gatekeepers such as JPMorgan Chase and Goldman Sachs since the financial crisis. Virtu and other relative newcomers, including Jump Trading, DRW Holdings, and Citadel Securities, as well as smaller, nimbler enterprises, are filling voids created by new regulations and technologies.
Virtu’s combination of microscopic electronic surveillance, lightning-fast algorithms, and rigorous risk management also explains why this relatively small company has become the most consistently profitable market maker in the history of electronic trading. “The discipline they apply to the wholesale market-making game is different than other firms,” says Rich Repetto, an analyst at Sandler O’Neill & Partners.
The consistency with which Virtu earns a profit is almost beyond belief. From 2009 to 2014, it lost money on only one day. (The aberration happened when it missed a special dividend payment for a stock, throwing off its model and causing a seven-figure loss.) In 2014, the last year it disclosed its daily win-loss ratio, Virtu was in the black every day, generating revenue of $723.1 million and net income of $190.1 million.
Rather than go for big trades that could blow up and lose a lot of money, Virtu prides itself on making small amounts—as in $10—millions of times a day. Between the Watcher’s sporadic warnings on that Friday in May, the company was making markets in gold exchange-traded funds and futures. Over a series of 23 transactions in Chicago and New York, it earned all of $36. “They’re consistently profitable in an area that’s not known for that,” Repetto says. Profitability, however, hasn’t prevented the company’s share price from slumping since its initial public offering in 2015.
What the company wants to do over and over is to sell to buyers and buy from sellers, not take positions of its own, and either hedge its risks at the end of the day or go home with no risk at all. It does this with stocks, currencies, futures, and fixed-income securities. All told, Virtu makes markets in more than 12,000 financial assets. The ruthless efficiency at its core is most evident when you consider that it trades on more markets (230-plus venues in 35 countries around the world) than it has employees (148 at the end of 2015).
Viola wears gray cotton pants and a black Dockers shirt, hardly a uniform that would make fellow cafe-goers on the Upper East Side notice that in their midst is a man worth $2.3 billion, according to the Bloomberg Billionaires Index. At 60, the former soldier is fit with short, cropped hair and dark brown eyes.
The Medium Is the Massage, the 1967 book by Marshall McLuhan and Quentin Fiore, changed his life. “I started to understand that the power of information and the way it was presented was almost as important as what was being said,” says Viola, who’s focused and intense and prone to touching you on the arm to emphasize a point. Raised in Brooklyn, N.Y., by a truck driver and a homemaker, Viola never set foot inside a business class. Yet he proved a natural fit on the floor of the New York Mercantile Exchange, where he jostled and shouted out orders in the crowded oil futures pit in the early 1980s. He eventually became a board member of the exchange and its chairman from 2001 to 2004.
Two events during his Nymex years convinced him that electronic trading was the future. As a director in 1989, a deal he was negotiating for a stake in the Chicago Mercantile Exchange’s electronic trading system fell through. Nonetheless, Viola was put in charge of Nymex’s newly created electronic trading committee. There he learned that a few years earlier, in 1984, Nasdaq had introduced an electronic trading method that automatically matched small orders against the best quotes in the market. In other words, Nasdaq had opened part of its market to be accessible from multiple locations, unlike the closed-system exchanges where traders had to be physically present on a floor. Viola may have been a bit late in picking up on Nasdaq’s innovation, a huge change in markets, but he nonetheless realized its importance. “That was my ‘Aha!’ moment—when I realized these markets were destined to be electronified,” he says.
Viola by no means carried out his revolution on his own. Doug Cifu, Virtu’s chief executive officer, has been at his side since Day One. A private equity lawyer prior to Virtu, Cifu met Viola through Bill Ford, now the CEO of General Atlantic, which in 2006 had bought a stake in Nymex. Three years ago, Cifu and Viola purchased the NHL’s Florida Panthers—which fills Cifu’s Twitter feed, unless he’s telling the world his son pitched a no-hitter and batted 4 for 4 in a Little League game.
Cifu, 51, points to probability theory and the millions of times Virtu trades every day to explain its winning ways. The law of large numbers dictates that the company, seeking only to earn the spread on each transaction and not bet on the direction of markets, will make money close to 50 percent of the time. (It loses a lot, too—on the whole its strategies just happen to win slightly more than they lose.) “This firm is about making a tick,” Cifu says. “We don’t hold on to positions.”
The former lawyer is brash and prone to cussing, which has helped make him well-liked on Wall Street. From 2012 to 2014 he and Viola more than doubled Virtu’s net income. Then, just as they prepared to take the company public, Michael Lewis published Flash Boys, about a team of former Royal Bank of Canada traders trying to launch an exchange, IEX. In the fallout, high-frequency trading companies came under fire for allegedly rigging the U.S. stock market. Virtu has never considered itself an HFT company, Cifu says, because it never holds on to the assets it buys and sells. Still, the business got caught in the media firestorm that followed Lewis’s book and shelved its IPO plans for a year.
That Virtu only makes markets and isn’t an HFT company “fell on deaf ears,” according to Mehmet Kinak, head of global equity market structure and electronic trading for T. Rowe Price. The circumstances also made Cifu adopt the role of corrector-in-chief. “There are some people who don’t appreciate the role of a market maker,” he says. “Natural buyers and sellers will never meet.” Then he adds a zinger: “Michael Lewis might not understand that.” (When asked for comment, Lewis responded: “The book did not make the unsubstantiated claim that the stock market was rigged. It described the extremely careful and persuasive tests run by RBC traders that showed how it was rigged.”)
Virtu is built to benefit from more electronic trading, Cifu says. The company doesn’t make money from inefficient markets, he clarifies—just the opposite. “The secret of Virtu is the scale and the efficiency we brought to the market,” he says. “The biggest misconception of this firm is we’re some nefarious quantitative firm with a secret algorithm.” Viola says being cast as a villain was “the most bizarre period of my life.” Yet he rallied the troops at Virtu—as he did while chairman at Nymex after the terrorist attacks of Sept. 11—gathering everyone on the New York trading floor to tell them, “We know we’re good actors.”
Virtu saw the moment as an opportunity to engage with the broader market and show how the company operated. Cifu played a star role in setting the record straight, according to Kinak; after Flash Boys, the CEO bared all to prove how his firm does its thing. As a result, Virtu ended up creating a service in late 2014 to execute trades for T. Rowe Price and broker-dealer Themis Trading. Kinak is a fan. The so-called agency business is “helping our cost of execution,” he says. Virtu’s technology and the way it sends orders into the market are superior to what T. Rowe was using before.
And then in early August, Virtu released a bombshell. It agreed to provide its order routing and execution services to JPMorgan, Wall Street’s largest fixed-income shop, for use in the $13.4 trillion U.S. Treasury market. Without naming the bank, Cifu had hinted at this development back in May. “I see more of these kinds of arrangements in the future,” he says.
Virtu’s consistent ability to generate profit aside, investors have so far been unimpressed. As of Aug. 1, Virtu shares had fallen 21 percent since its April 2015 IPO. “Despite a decent environment, it seems like they haven’t lived up to expectations,” says Alex Kramm, an analyst at UBS. That may be because the company is a bit of a black box, he says; investors are unsure of Virtu’s ability to sustainably expand its business and not lose market share to competitors such as KCG Holdings, Citadel Securities, and Global Trading Systems. A promising development is the agency business: Kramm expects the strategy to be a big part of Virtu’s future, helping to increase revenue by as much as 15 percent in the next two years.
According to Kramm, one disadvantage of the company’s business model is that amid all the assets Virtu trades, it’s difficult to get a view into what’s driving the bottom line. Take foreign exchange. “FX has been a challenging area for them in terms of not growing as fast or being down in some quarters,” he says.
He also notes the rich irony that, for a company buying or selling just about any financial asset under the sun, it’s difficult to get Virtu shares on the open market, because so few are available. “It’s a hard stock to buy and sell,” he says.
Cifu says analysts and investors need more time to understand “the push-pull of our business.” And being a bit opaque is intentional so as to not “create a road map” for competitors. Still, he acknowledges having to balance that with convincing investors that the company can increase its profitability.
Another challenge Virtu may face, especially as it steps into markets that have traditionally been the domain of the JPMorgan Chase crowd, is that the tiny company will open itself up to stricter regulation. After 2008, regulators have demanded more safety and accountability from all segments of market infrastructure. Viola remains undeterred. “I don’t fear regulation. I embrace regulation,” he says. “We have a duty to make people understand what, to the average person, is complex and frightening.”
He also embraces penny-pinching. When Virtu moved into its new office a few years back, the space had been occupied by a hedge fund that vacated in such a hurry it left behind all its office furniture and a gym with treadmills, stationary bikes, and free weights. Viola and his executives decided to keep everything. “Every penny spent impacts the bid and offer we make,” Viola says. “Every penny.”
That same tight cost control seems to apply even outside Virtu’s walls. Matthew Andresen, a market structure pioneer who’s the co-CEO of Headlands Technologies, has known Viola and Cifu for years. On a trip to Miami, Andresen and his wife—a huge hockey fan—decided to catch a Panthers game. Andresen called Cifu and Viola to score seats that would impress her. They hooked him up—and later sent him the bill. “God bless these guys,” Andresen says with a laugh. “They run a tight ship.”
Virtu’s melding of man and machine is nowhere more evident than on its trading floor. There are no stars here—or, as Cifu puts it, “no Ferraris, no yelling, no bowls of guacamole on the trading floor.” (He did give in and provide fruit plates after complaints the snacks were unhealthy.)
On the May day when the Watcher was flagging issues, Cifu stood among his traders. The wayward currency order had been confirmed as canceled after seven seconds. “You have to understand this on a microsecond-by-microsecond level,” he said. One of the risk managers sat nearby. Asked what he was monitoring on the 20 windows spread across three huge screens in front of him, he replied, “The world.” (Executives requested that his name not be used to adhere to Virtu’s no-stars policy.)
“We can shut off Japan from here, which we have done,” Cifu said, referring to the company’s operations. Then he boasted that Virtu’s risk-management systems—all of which were built from scratch—are so good, the company is often the one to alert a market to its own issue. Cifu said, “We’ll call an exchange and say, ‘Hey, are you having problems?’ And they’ll say, ‘Umm, we don’t know.’ And we’ll say, ‘Go f—ing check.’ ”
Odds are, Virtu was halfway through another profitable day. To that, the Watcher has no retort.
Fourth consecutive monthly increase in U.S. market share and record for POSIT