Since it was publicized that trading firm Virtu Financial had only one losing day during six years, there has been rampant speculation and suspicion as to what they actually do. We get it straight from the horse’s mouth in a conversation with Virtu CEO Douglas Cifu.
Modern Trader: Virtu calls itself a market-maker. Is that the best definition from a trading perspective?
Douglas Cifu: That is 100% our style of trading. We make two-sided bids and offers on about 11,000 financial instruments: Stocks, derivatives, spot forex and options. It’s a widget. We’re making two-sided prices for those instruments, whether it’s a share of IBM or a euro/U.S. dollar currency pair. We’re completely agnostic to the direction of a market. What we do very well is try to figure out the unique price of an instrument, obviously by referencing market data. Then we say we’re willing to buy at five and sell at six, and we’re willing to do that continuously throughout the day. I’m generalizing a little bit, but 99% of what we do is post passive bids and offers and wait for people to interact with us. That’s the business. It’s an old school market-making function; however, it has evolved through technology, automation, and efficiency.
MT: How many markets are you actively in and how much capital are you trading?
DC: We are in more than 225 markets in 35 countries and we operate 24 hours a day from our four trading centers: Singapore, Dublin, Austin and New York. In terms of capital, we have a very complicated balance sheet, if you look at our 10-K and 10-Q, because we have two self-clearing broker dealers in U.S. equities. We have somewhere in the neighborhood of $275 million to $300 million of trading capital that we apply every day to the market.
MT: Virtu went public earlier this year. When you were taking your strategy to investors, how did you differentiate yourself?
DC: Let me give the background on why we included the histogram in the S1 and how powerful it was in our ability to access the public markets. Virtu is not a trading firm in the traditional sense, so we’re not making directional bets on markets; we’re not a stat-arbitrage firm. We’re not a quant firm. Now, there’s nothing wrong with those firms, but they tend to have P&Ls that are more erratic. Our idea was to show investors, if you look at our profitability, that it’s not that we make money every day; it’s that the P&L that we generate is very tightly packed. Between X and Y (you can look at the S1 and see what the exact numbers were) it really tries to validate the proposition that we’re a market-making firm. We’re not swinging for the fences; we just hit a lot of singles. For us it has been about showing that the DNA of this firm is about trying to make that bid-offer spread.
MT: What was the reaction to that philosophy?
DC: When we were on the road show, it was very effective because investors that were willing to look beyond labels and irrelevancies saw that and said, “I get it. This is really just trying to provide that market-making service through the use of technology. So, it’s very repeatable, it’s automated and I can get a pretty good feeling that, ultimately, over time they’re going to continue to be successful.” It served its purpose, and it was very effective for those who were willing to look beyond the histrionics.
MT: Virtu had one losing day in six years. How did you accomplish this? And what went wrong on that one day?
DC: To me, that second question is the more important one. There’s an interesting article that came out in The Wall Street Journal about a year and a half ago, before we went public, but after Michael Lewis’ book. If you look up something called “the law of large numbers,” a professor (Greg Laughlin) at Santa Cruz—whom I’ve never met before in my life—was fascinated by our win success rate. He said that if you trade more than 800,000 times a day, and you’re up at least 51% of the time, you are statistically unlikely to lose money over 800 years, or some similar time frame. It’s basic statistics; we trade more than five million times a day.
It’s really just a question of scale. I’ve always said that we do lose money every day. We lose money millions of times a day. We take risks. We get into positions that are losers and then we get out of them. That’s what we do. We are taking risk as a market-making firm. Fortunately, we’ve had more winners than losers and so, when you apply that basic statistical analysis over that period, that’s why we make money every day. The day that we lost money, we had an operational error. We mispriced an option and traded off value. That’s the risk of a market-making firm, that’s why you got to have a lot of risk control. Obviously we weren’t happy about that, it wasn’t a monumental loss, it was a couple of million bucks. We learned, we corrected, we put safeguards in place and it hasn’t repeated itself.
MT: Wall Street has always been a hub for Finance MBAs. It seems you’re only hiring people who have that tech background. Have you noticed an educational evolution during the last 10 years?
DC: It’s been a fascinating trend. We’re not a trading firm; we don’t pay like a trading firm. We don’t have pockets of traders, we don’t have guarantees, we don’t have percentages of P&L. There’s nothing wrong with that, but we architected this firm much more like a technology firm: It’s all-for-one, one-for-all. There’s one pot of money and people get paid discretionary bonuses every year based on performance, and those don’t have to correlate to a P&L.
We are 100% a technology firm and there are some incredibly brilliant people working here. We IQ test and then test problem solving skills. It’s not because we’re a quant firm and I need high quantitative math skills. The markets are a complicated mix. It’s been very publicized. The fragmentation, [various] order types, maker taker [pricing] and all the different markets and technology just in U.S. equities. We connect to 40 different venues. To be a U.S. equities market-maker, that problem of the market and how that all integrates, you need folks with the IQ to figure it all out. You need people that understand technology. Obviously what we do is highly automated, it’s all algorithmically based; it’s no voice, it’s no IM chat. It’s all automated and algorithmic, and so, yes, we have people that we call developers that are developing that code, but the young man or woman that’s a trader, that is applying that code to the problem set and doing the configurations, has to at least be literate in that language, not just in computer language, but in understanding how algorithms work because they have to understand and work with the developers side-by-side.
MT: What are the other contributors to success?
DC: One of the keys to success is communication, and everyone says this: Integration of front and back office. Well, we don’t have a front and back office. We have developers who sit on a trading floor that understand everything about the trading strategies but don’t actually trade. They’re watching the algorithms and making sure they’re working properly. Then you have people who are designated as traders or risk managers that are actually doing the configuration and watching the strategies during the day—adjusting and trying to respond to market conditions, but they also understand the algorithms themselves.
Then when the trading day’s over—and we do post trading day analysis—then we say, “Hey, we did well here and we didn’t do well there; with this batch we made money, with this batch we lost money.” You want the trader to be able to speak that same language as the developer so that you have peer telepathy between the two. That’s why, at least in our style of firm, you’ve seen the evolution of the employee be a physicist who’s got a PhD, not because he’s a brilliant mathematician, but because technology and computing languages and understanding code are how he’s always learned and solved problems.
It’s not like we’ve got a room full of computer developers, we have a lot of chemists and physicists. Applied chemists end up being some of our best employees. They’re not developers, but they’re very good at
practical problem solving.
MT: Recently, you said that Russia is an increasingly attractive market. Do you have any concerns about recent geopolitics in the region?
DC: From a market-making perspective, Russia is attractive because it’s really a microcosm of what we do. They have the robust cash equities market, they’ve got, I think, the only really regulated spot FX market in the world on MICEX. They also have commodities futures contracts that trade pretty robustly. They’ve got a Brent contract and some metals contracts. If you look at the marketplace, it’s really a little bit of a microcosm of everything we do. It’s nice to spend the money in the infrastructure and to learn the DNA of how a country’s markets work, and have that full microcosm of opportunities set for us, because, remember, we’re a market- maker in forex, we’re a market-maker in energy, we’re a market-maker in cash equities. My dream would be that every country had its own robust futures exchange and currency platform and more because it would provide more opportunities for us.
MT: Recently, Michael Coscia was found guilty in a Federal spoofing case. What are your thoughts on that case? Will it lead to additional regulations?
DC: We’re a very large market participant, so we are the firm [as ironic as this sounds] that is often the victim of spoofing. We’re placing a ton of passive bids and offers in 225 markets. [There are] people that are sending orders to exchanges that are not intending to execute them, that don’t have a bona-fide intention to execute them, are intending to manipulate passive bids and offers that are resting on the order book, or to encourage people to take action with respect to either supplementing those or modifying them or cancelling them. We don’t do any of that. I’m not sure how that all works, but that’s clearly, based on what I’ve read, the intention. Market-making firms’ – like Virtu and others – bids and offers will react to what’s happening in the market state, so if you’re going to try to hedge fake or spoof our trading algorithm, it’s more likely going to be a market-making firm like ours that’s going to have bids and offers. Over the last seven or eight years, certainly we have seen instances of flickering quotes that looked questionable, where we have taken action in the following two manners: We’ve made sure that our market-making algorithms are smart enough to say, “If an order comes in to the order book, three or four levels down, and it doesn’t have a duration of more than X milliseconds, ignore it.” Not because we don’t have any idea what it is, but it doesn’t appear to be something that wants to be executed. Our system doesn’t react to it. It doesn’t adjust the view of fundamental value of that instrument you’re trying to apply liquidity to, because you’ve seen large size three or four levels off the book. Classic spoofing or layering. We call those anti-gaming logics.
MT: How else have you reacted to orders that aren’t meant to be executed?
DC: In a handful of instances we’ve actually taken snapshots of that market data and we’ve given them to the CFTC, FINRA, CME, ICE [or to] IIROC in Canada. We try to police the markets as best as we can because we don’t like to be the recipient, or the victim, of orders that are placed that are not intended to be executed. We obviously applaud the efforts of regulators trying to weed out participants that don’t really have a bona-fide intention to execute into the market. With that being said, market-making firms and other participants cancel a lot of orders, and we do it for really good reasons, because every bid and offer that we put into an order book, we intend to be executed. That’s real live risk to our firm. If other bids and offers in the market state have changed, our algorithm in Virtu may change its fundamental view of what fair value is, so therefore we try to cancel orders where we think that we are now not pricing correctly the risk associated with a particular instrument.
MT: Can you offer an example of how that works?
DC: I’ll give you a classic one. There are futures that trade in Chicago, they’re ETFs that trade in the New York region at the three large data centers. If somebody comes into the order book in Chicago and buys a bunch of gold futures, the price of GLD should change in New York. You’ll see firms like Virtu and others, when the futures trade in Chicago, cancel a bunch of orders and replace them at different prices where the exchanges are located. That’s perfectly acceptable market-making and reaction to market-making activity. Critics will look at that and say, “Hey, Virtu is placing and canceling a lot of orders.” It can happen sometimes within 10 or five milliseconds, but that’s because our view of fair value has changed, and we’re trying to manage our risks. That’s all that’s happening. To me, there’s a very clear distinction between legitimate risk mitigation activities and spoofing orders that have no bona-fide intention of being executed.
MT: Let’s turn to your other endeavors. You and your business partner Vinnie Viola recently purchased the Florida Panthers. What drew you to the NHL?
DC: Vinnie is one of my best friends and we thought, “Hey, we’re both sports nuts, if we apply that operating rigor and data analysis to a professional sports franchise, maybe over a period of time we could build a championship team.” We both love hockey. Vinnie had a prior experience with being a partner in the group that owned the New Jersey Nets. We were looking for a situation that made sense. We both like the demographics of hockey in that they have a salary cap and revenue sharing and they have media contracts that were growing, and all the other things that people talk to about ascending values of franchises. All those things made sense. Most important, I love Florida. I have a house down there and at some point in my life I would like to become a full-time resident. Vinnie felt the same and so when the Florida Panthers became available in 2013, we pounced on the opportunity.
MT: What’s your time frame to make a run for the Stanley Cup?
DC: You have to be patient. We’re seeing players from the 2010 NHL draft, which is before Vinnie and I owned the team. GM Dale Tallon is in his sixth year; 2010 was his first draft class. Yesterday we had five or six young men on the ice from that class. We had two from 2011; 12 of our 20 dressed players were drafted by the Panthers. The key to building a franchise is to build within. Dale did it when he was GM in Chicago. He drafted Jonathan Toews, Patrick Kane and Brent Seabrook. He added smart, terrific veterans like Marian Hossa and Dustin Byfuglien during his time when he was there. You saw how Chicago was built. We’re seeing that same pattern here in Florida where our most talented players and the core of our team are under the age of 23 or 24. Whether it sparks and hits this year or next year or the year after, we’re very confident in the five-year plan here. As I tell everybody, “See you at the parade in on Las Olas Blvd.,” which is like the Broadway of Ft. Lauderdale.
MT: Turning back to the financial industry, what else has you excited about the future?
DC: As traditional financial institutions face the pressures of regulation—particularly with the Volcker Rule, but also Dodd-Frank and Basel III—and try to transform their models to this agency efficiency model, there’s going to be enormous pressure for them to become more efficient. Firms like Virtu can offer a solution. We’ve been approached by a number of financial institutions. For example, we are in the midst of a very successful experiment with T. Rowe. They used to be a critic of high frequency trading. Now T. Rowe is sending us orders that we’re using our technology and routers to execute on their behalf. That’s a traditional agency broker business, it’s not a business that I ever thought that Virtu had a differentiating model. We have a way to access the market in a very low-cost, efficient way. How you marry traditional Wall Street and traditional financial services roles with firms like ours, which can offer a very similar service and maybe on a different scale with a lot more efficiency—like those Virtu makes—to me, that will be interesting to watch over the next few years.