The market makers find the small trades attractive, because they are less likely to move the market than the massive trades made by big institutional investors. Handling high volumes of small trades allows firms like KCG and Citadel to make reliable profits. The market makers collect the "spread" between the price paid by a buyer and reaped by a seller, while still vowing to give customers comparatively advantageous prices.
TD Ameritrade spokeswoman Kim Hillyer said the firm does not comment on regulatory actions. A spokeswoman for E*Trade said the firm ensures that clients get the best possible execution of stock orders by conducting regular internal and external reviews. A Schwab spokesman said Schwab routes orders to wholesalers based solely on which one gets customers the best prices.
Citadel points to statistics showing that the average price paid by investors on most stock trades has declined steadily in recent years, as high-speed firms such as itself have assumed a greater role in market-making on electronic exchanges.
Critics say these statistics might not tell the whole story. Most of these statistics are based on a relatively slow data feed that lists current stock prices, critics say. Market-maker firms have access to numerous faster data feeds showing more up-to-date prices.
Investigators believe this information gap means that a firm could claim it got the optimal deal for a client based on the prices on the slower data feed, even as the firm knew a better price existed on a faster feed. Securities lawyers say this could constitute a breach of a firm's legal obligations. In December, the U.S. Financial Industry Regulatory Authority warned firms against the practice.
Crucial Milliseconds
Justice Department investigators seem interested in what Citadel's high-speed traders do with a stock order between the instant Citadel receives that order from a retail brokerage and the moment it ultimately executes the trade on behalf of a client, according to people familiar with the probe.
The blink-of-an-eye process usually takes Citadel upwards of 20 milliseconds, or 20 one-thousandths of a second. That's a long time in the world of high-frequency trading, however, where it takes seven milliseconds for a signal to travel between New York and Chicago.
The Department of Justice is using a statute known as the Financial Institutions Reform, Recovery and Enforcement Act, or Firrea, to conduct its probe. Adopted in 1989 during the savings-and-loan crisis, Firrea was dusted off and redeployed by prosecutors after the 2008 financial crisis.
The statute empowers the Justice Department to pursue criminal violations involving banks by pursuing a civil lawsuit, which has a lower standard of proof, to collect penalties. In contrast to facts produced by grand jury subpoenas used in a criminal probe, which are tightly held, information gleaned from a Firrea subpoena can be shared more freely with other prosecutors and enforcement agencies.