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After dropping $2B in M&A, Virtu Financial enters its next act

It is a new era at Virtu Financial Inc.

As one of Wall Street's fastest and biggest trading shops, Virtu spent its first decade making a name for itself through the high-speed technologies and complex algorithms it uses to trade its own money around the world. Now, after doling out more than $2 billion in acquisitions over the last two years, the New York-based trading titan must convince its newest clients that it can fuse together some of the world's most storied trading franchises under one roof to create a global financial technology player capable of serving the entire investment community — and not just itself.

"We were never really quant traders. All the things that Michael Lewis and others accused us of being, we actually aren't," Virtu co-founder and CEO Douglas Cifu said in an interview, referring to Lewis' 2014 best-seller Flash Boys, which villainized high-speed proprietary trading as a practice that preyed on slower-moving investors.

"We are really a financial technology firm that's very good at connecting to markets, understanding risk and trying to provide that intermediation between natural buyers and natural sellers," Cifu said.

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Born amid the wreckage of the 2008 financial crisis, Virtu was formed in part by Cifu and Chairman Emeritus Vincent Viola as a proprietary trading company specifically focused on making markets.

A practice long dominated by big banks, market makers provide liquidity by buying and selling assets throughout the trading day while collecting a small price differential in each of their trades. Those amounts can add up for a company like Virtu, which conducts north of 5 million trades daily across equity, foreign exchange, futures and commodity markets, among others.

When Virtu hit the public markets in 2015, the company said it had seen a profit every single day, other than one, for 1,485 trading days between 2009 and 2014.

Today, Virtu operates in 235 markets across more than 35 countries. The company has also been able to expand into the vast majority of those geographies with a relatively flat headcount, a feat Cifu attributes to his company's risk management strategies and its scalable technology infrastructure. Throughout much of its history, Virtu has consistently had about 150 employees, according to a review of the company's annual reports.

"The markets have demanded more efficiency and more scale," Cifu said. "We didn't get trapped into the psychology of saying, 'Oh, we're going to be the best at U.S. equities or FX or commodities.'"

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Still, the proprietary market-making business has faced growing pressure in recent years, something Cifu has acknowledged during times of low volatility such as the first quarter of 2019. Spreads between buy and sell orders have narrowed and costs for trading necessities like market data feeds have escalated, factors that have driven some smaller competitors out of business.

"You can have faster connectivity or a better algorithm, but the next time someone else gets a better algorithm, you're dead," said Larry Tabb, founder and research chairman of the trading advisory company TABB Group, in an interview. "The proprietary trading-market making business has gotten very competitive. To drive that forward, [Virtu] needed to cement their position in the market. They really needed to have a client-facing business."

Enter KCG Holdings Inc.

At $1.42 billion, Virtu's 2017 purchase of KCG marked the company's largest acquisition to date. Formed by a merger between high-frequency trading pioneers Knight Capital Group Inc. and GETCO Execution Services LLC, KCG finally gave Virtu a foothold in the retail wholesale market-making business where online brokerages like Charles Schwab Corp., E*TRADE Financial Corp. and Robinhood Markets Inc. rely on big trading firms and investment banks for executing their clients' orders.

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Virtu Financial CEO Douglas Cifu, left, and former Executive Chairman Vincent Viola, right, during Virtu's IPO in 2015. Cifu and Viola led the creation of Virtu in 2008 as a market-making business.
Source: Associated Press

That steady stream of retail order flow is highly coveted for companies like Virtu because retail traders tend to be very loyal to the companies they trade with, several industry participants said. Virtu executed nearly 25% of retail shares for S&P 500 securities with orders between 100 and 1,999 shares in January, putting its market share behind only Citadel Securities LLC, according to data from TABB Group and IHS Markit.

While the KCG acquisition provided Virtu with a sizable new business, the company was not done yet.

A year after acquiring KCG, Virtu made its second-largest purchase ever at $1.11 billion for Investment Technology Group Inc. Known as ITG, the company was formed in the late 1980s by Jefferies Group LLC and specialized in facilitating trades for big institutional investors. ITG also helped form the world's first-ever electronic equity trade matching system, POSIT, soon after its founding.

Both KCG and ITG are expected to stabilize Virtu's income. Prior to the KCG deal, Virtu received 96% of its net trading income, which accounts for the vast majority of its revenues, from market making and only 4% from recurring technology and execution services. While in some quarters market making can be a booming business for Virtu, calmer markets can also drive down trading activity and cut into the spreads that market makers rely on. Virtu's volatile stock price has mirrored its inconsistent revenue trends.

Once ITG is fully integrated, though, Virtu expects only 62% of its net trading income to come from market making while the remaining 38% will hail from technology and execution, according to the company's most recent annual report.

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Now, the breadth of Virtu's operations is also straining the limits of the lean operating model Cifu has favored for years. The company must get all of its 1,241 employees to buy into its newfound status as a global trading company that extends far beyond its proprietary trading roots.

To do that, Cifu has expanded the company's management committee to include legacy KCG and ITG employees whose knowledge of Virtu's newly added businesses far surpass anyone else's, he said.

"It's not done by Virtu people exclusively," Cifu said. "Knight was a much better firm and a better regarded firm than Virtu was. It had these great, sticky and meaningful client franchises. The same applies to ITG, [which] is a much better institutional business than Virtu, even with KCG, could ever have imagined to be."

Virtu has entered new business lines including an expanded global agency brokerage business, trade analytics and commission management, among others. The company means to keep those ITG legacy operations and has signaled it is investing in them.

At the same time, Virtu has already started cutting expenses in the two months since the ITG acquisition closed. The company's combined workforce has dropped by about 11% since the end of 2018, Virtu said while reporting its first-quarter results.

But arguably the biggest hurdle Virtu faces as it looks ahead comes from the investment community, where some market participants have aired concern about the company's ownership of ITG.

As an agency brokerage, ITG serves asset managers, pension funds and other institutional investors around the globe — the same market participants that high-speed traders like Virtu have been accused of fleecing for their own profits. Skeptics of the deal fear that Virtu's proprietary trading desk, mostly based in Austin, Texas, will take advantage of the company's institutional clients by peeking at their orders when they are sent to Virtu.

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Thus far, Cifu said Virtu has taken a handful of other steps to reassure its new clients about the division between its proprietary and agency businesses, including moving all of its broker-neutral business to a separate floor than the rest of its trading operations at its New York headquarters. Virtu's most sensitive client businesses — including its transaction cost analysis system — operate in a part of the company's offices that is only accessible with specific key cards. The company has also moved to secure client data that otherwise would be accessible internally. To address those lingering concerns, Virtu held two client information security meetings in April where the company described its plans to secure client information to more than 100 industry participants.

"We're going the extra step to physically and obviously logically separate our businesses," Cifu said. "We're not screwing around."

Not all of the buy-side is as concerned, though.

"We haven't seen anything but a clean bill of health from Virtu for all these years we've engaged with them," said Mehmet Kinak, global head of systematic trading at Baltimore-based asset manager T. Rowe Price Group Inc., in an interview. "Until I'm proven wrong on them, I'm going to believe in the relationship that we have, which is built on transparency and trust."

T. Rowe Price, which oversees $1.082 trillion, has been working with Virtu for about six years, according to Kinak, who said the ITG acquisition clearly signals Virtu's interest in expanding beyond market making and not bolstering the business. Kinak added that mining information from agency order flow is "not an easy proposition," let alone one that would be worth the amount of money Virtu spent on ITG.

For now, Virtu remains fixated on resolving any lingering concerns about its ownership of ITG and integrating the companies' technology infrastructure together. But the company's evolution is likely not yet complete.

"We're a broad financial services firm now," Cifu said. "The idea is to grow organically and look opportunistically where we think we can create value for our shareholders by helping scale a business that is either operationally inefficient or needs a technological refresh."

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