Paying For Order Flow

Established in 1995, Knight was a pioneer of electronic market making. It has had previous run-ins with authorities over its handling of customer trades. In 2002, Knight paid $1.5 million to settle regulatory charges related to its market-making operations. In 2004, Knight paid $79 million to settle SEC allegations that it had overcharged customers.

Today, KCG is second only to Citadel in the market for handling stock order flow from retail brokerage firms.

KCG and many other high-frequency trading firms have shied away from the public spotlight. KCG, for example, has appeared to pivot away from some of the market-making activities now coming under scrutiny. In February, KCG sold its market-making seats on the floor of the New York Stock Exchange to Citadel.

Citadel has taken a higher profile. Last year, it set off a price war with rivals that enabled it to expand its share of the market-making business. Citadel also has argued vocally in the media, and to regulators, that its wholesaling operation is good for investors. The head of Citadel Execution Services, Nazarali, secured a seat last year on the SEC's new Equity Markets Structure Advisory Committee, where he has cast himself as a spokesperson for the interests of retail investors.

The Justice Department inquiry appears aimed at a pillar of the market's structure: the strategy whereby market-making wholesalers such as Citadel pay retail brokerages for their clients' order flow.

The practice of paying for order flow, per se, is legal. But it also has been controversial, going back to the days of disgraced Wall Street investment manager Bernard Madoff, who pioneered the practice of buying client trades.

Critics contend that practice poses a potential conflict of interest for retail brokerage firms: They may be tempted to sell customer orders to the highest bidder rather than to the market maker who will obtain the best prices and fastest execution for investors. A related question has dogged the market makers: Why are firms willing to pay for stock orders if they are in turn executing those trades at the best available prices?

Small, day-trading investors make up the majority of the customers of mass-market brokerage firms such as TD Ameritrade, Charles Schwab and E*Trade. These firms sell their stream of stock-trading orders to market makers such as Citadel and KCG.

Attractive Customers