In depth: Citadel Connect and Dark Pools discovered

Neither the author, Tim Fries, nor this website, The Tokenist, provide financial advice. Please review our website policy before making any financial decisions.

Before dark pools, institutional investors had to trade blocks of shares outside of trading hours to avoid disrupting the market. Now the utility found in dark pools is so high that some market makers have incorporated them into their operations. There are certainly advantages here in terms of increased liquidity, but there is also another side of the coin.

Throughout 2021, retail traders discovered significant short positions held by hedge funds in a number of stocks. Naked short selling is suspected by many retail traders to be involved. At this point, hedge funds have collectively lost $ 12 billion – so far.

One of the latest developments in this saga is Citadel Connect, a dark pool operated by Citadel Securities.

Citadel Securities and Citadel Connect

If you haven’t followed the WallStreetBets saga in multiple Senate Banking Committee hearings, here’s a quick recap. As the largest Designated Market Maker (DMM) on the NYSE and accounting for 47% of US retail trading volume, Citadel Securities LLC also accounted for a significant portion of Robinhood’s revenue in Q1 2021. thanks to Robinhood’s PFOF (payment for order flow). business model.

PFOF is a very controversial practice because it tends to cause conflicts of interest, which is why it is illegal in many Western countries (UK, Canada and Australia). Current SEC Chairman Gary Gensler noted some places of his abuse on June 9e.

“Payment for order flows raises a number of important questions. Do brokers have inherent conflicts of interest? If so, are clients getting best execution in the context of this conflict? Are brokers encouraged to encourage clients to trade more frequently than in the best interests of those clients? “

In the same statement, Gensler further noted that around 9% of January’s trading volume was executed on Alternative Trading Systems (ATS), commonly referred to as dark pools. True to their nickname, Dark Pools have the effect of obstructing market resolution. In stock market parlance, the aggregate quotation report on the bid-ask price spread – the National Best Bid and Offer (NBBO) – is skewed, as Gensler himself noted:

“First, as evidenced in January, nearly half of the commercial interests in the equity market are either in dark pools or is internalized by wholesalers.

Internalization means that the order is not routed to the market maker but that the broker himself fills the order from his stock inventory. For example, Citadel Securities was fined $ 22 million in 2017 for “misleading statements suggesting that it would provide or attempt to obtain the best prices that it has seen for retail orders routed through other brokers,“.

Continuing with the dark pools, Gensler then concluded the following:

“Dark pools and wholesalers are not reflected in the NBBO. In addition, the NBBO is as good as the market itself. Thus, within the framework of the current market segmentation, nearly half of the exchanges as well as a significant part of the orders of the retail market take place outside the informed markets. I think it may affect the bid-ask spread width. “

Citadel Securities owns and operates one such dark pool out of the 50 currently in the United States, called Citadel Connect.

What is a Dark Pool and can it be abused?

Alternative Trading Systems (ATS) or Dark Pools are private exchanges that have liquidity advantages but can also hide trades. Together with internalisers, they represent over 40% of the global stock market. Dark pools gained ground after 2005, following the SEC’s adoption of the National Market System (NMS) regulation. NMS modernized the stock market to make it as we know it today. Therefore, dark pools are completely legal and regulated.

However, they are called dark because the orders do not appear in the stock exchange order books. The obvious purpose of this feature is to stabilize the market, so that when large orders from institutionalized investors are placed, other market participants are not alerted. Otherwise, with the size of the order in the open – in the enlightened market – other participants would be able to trigger a downward price change.

By preventing this from happening, dark pools increase market liquidity and efficiency. However, in the same way that dark pools eliminate transparency by design, they can also hide conflicts of interest. Here are some historical examples that demonstrate the ways dark pools have been abused:

  • On October 3, 2012, SEC accused eBX LLC of failing to protect the confidential information of its subscribers, allowing third parties to use that information.
  • On June 6, 2014, the SEC accused a New York broker of mishandling confidential information and using it for marketing purposes.
  • On January 15, 2015, the SEC accused UBS Securities LLC of failing to disclose a type of order that it issued exclusively to market makers.
  • On August 12, 2015, the SEC indicted ITG and AlterNet Securities for operating a secret trading desk and misuse of confidential trading data.
  • On January 31, 2016, the SEC indicted Barkley Capital and Credit Suisse for numerous violations, including the execution of 117 million illegal subpenny orders.
  • On September 14, 2018, the SEC accused Citigroup of misleading dark pool users and of routing orders on other trading venues.
  • On November 7, 2018, the SEC indicted ITG and AlterNet Securities again for violations similar to last time.

This gives you insight into the range of abuse occurring in dark pools. That said, as a private exchange, each private pool has its own rules and limits. For example, some only allow large orders or blocks, while others focus on high frequency trading (HFT), which is how dark pools gained popularity in the first place.

The most common abuse found in dark pools is so-called front running. Knowing that a trader is about to execute a trade, another trader can first trade the stock – sell or buy – then sell it to meet the initial demand – at a profit.

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Is Citadel Connect a Dark Pool?

Numerous reliable reports suggest that Citadel Connect is indeed a dark pool. Interestingly, however, Citadel Connect is not registered as an ATS, nor does it report its trading volume to FINRA, which is overseen by the SEC, according to a 2015 Reuters report:

“Unlike Apogee, Connect is not classified as an ‘alternative trading system’ and does not report volumes to FINRA.”

In the same article, Reuters reported that Citadel Securities was aiming to shut down its previously registered dark pool called Apogee in 2015, as Citadel Connect had already outperformed it by five times. The market maker itself refers to Connect as “over-the-counter trading” or “immediate order or cancellation (IOC) platform”. Among its offer are the following features:

  • Single core liquid deep
  • Minimize the impact on the market
  • Intelligent order routing

These characteristics correspond to the objective of dark pools. However, SEC Chairman Gary Gensler differentiated between dark pools (ATS) and over-the-counter wholesalers, observing that:

“That leaves around 38%, most of which were executed by over-the-counter wholesalers. Only seven wholesalers represented the vast majority of this group…. Within the space of over-the-counter market makers, we are seeing a concentration. One company has publicly stated that it is running almost half of all retail volume. “

As you can see, the market is all about the flow of information and which entities have positioned themselves to best exploit that flow of data.

“… given that a large and growing portion of retail orders are channeled to a small, concentrated group of wholesalers, some market makers have more data than others.

As we have seen in many other parts of our economy, there are a few central players benefiting from the growing use of data, whether in research, e-commerce or, in this case, transaction flow data. .

It’s impossible to say how this state of affairs applies to the short squeeze of memes stocks until the conclusion itself unfolds.

Do you think Citadel Connect is being used to benefit all parties involved with additional liquidity as proclaimed by spokespersons for Citadel Securities? Or is there another part of the in-game image that is finally uncovered? Let us know your thoughts in the comments below.

About the Author

Tim Fries is the co-founder of The Tokenist. He has a BSc in Mechanical Engineering from the University of Michigan and an MBA from the Booth School of Business at the University of Chicago. Tim was a Senior Associate in the investment team of RW Baird’s US Private Equity division and is also a co-founder of Protective Technologies Capital, an investment firm specializing in detection, protection and protection solutions. control.


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