Citadel v. SEC: Fast and Furious
The latest battle over high-speed trading is being fought out in one of the nation’s federal appellate courts. The subject this time is a new order proposed by Investors Exchange LLC (“IEX”), the Discretionary Limit, or D-Limit, order. IEX’s stated mission is to protect investors, institutional and individual investors alike, from latency arbitrage, a strategy practiced by high-speed trading firms.
First, some background. In 2016, the SEC approved IEX’s exchange, along with rules to discourage predatory behavior of some market participants by combatting latency arbitrage. IEX’s early innovation, known as the “speed bump,” consists of 38 miles of coiled fiber-optic cable, which adds 350 microseconds (350 millionths of a second) to the time it takes an order to reach IEX’s system. The purpose of the speed-bump is to blunt the advantage of high-speed traders, which look for signals that other buyers and sellers are in the market and then insert themselves ahead of the slower orders so they can profit from short-term trades.
Latency arbitrage, the target of IEX’s speed bump, is a strategy utilized by a small number of firms with the wherewithal to invest in high-speed infrastructure. The technology allows the firm to predict price changes, leverage small latency advantages and trade opportunistically against stale quotes. Say a stock price is in the process of increasing by a penny across different exchanges. Armed with the advantage its technology affords, the high-speed trader can buy at the lower price from an investor who does not have the tools to change its quote fast enough and sell at the higher (by one penny) price.
All of this happens in roughly 300 microseconds, a small fraction of the time is takes to blink your eye. That’s why a 350-microsecond speed bump erases the advantage of high-speed traders, who are denied signals that other buyers and sellers are in the market.
According to IEX, the speed bump, while effective for market orders, does not provide protection against predatory strategies for investors who place limit orders. Its D-Limit order, which IEX proposed to the SEC in 2019, permits traders to publicly display the highest price they are willing to pay to buy or the lowest price at which they are willing to sell until IEX’s Crumbling Quote Indicator (“CQI”) is triggered. The CQI uses a sophisticated empirical model that predicts when prices are about to change. At that point, the order is repriced, typically by a penny, to protect the trader from poor execution. The high-speed trader is thus prevented from trading at the stale price. According to data IEX provided to the SEC, CQI is typically activated for far less than 1% of the trading day, while 24% of trades occur within that brief period.
On March 27, 2020, the SEC instituted proceedings to determine whether to approve or disapprove IEX’s proposed the D-Limit order. The SEC considered 51 comments from various market participants and conducted meetings with 17 of them. The agency analyzed extensive data from IEX submitted in support of the rule.
The SEC ultimately found that the D-Limit order type was a narrowly-tailored means of mitigating the effects of latency arbitrage for long-term investors. The agency predicted that the order type would encourage more displayed liquidity on IEX, as several investors with institutional trading experience commented that market participants were reluctant to post displayed liquidity because of their experience of having that interest adversely selected by high-speed traders, whose technology they could not afford and with whom they could not compete. The lack of displayed liquidity, the SEC concluded, harms price discovery and leads to greater off-exchange trading, which can negatively impact markets and market participants.
Citadel Securities LLC, a high-speed trader, which submitted the most aggressive comments to the SEC opposing approval of the rule, petitioned the United States Court of Appeals for the District of Columbia Circuit to vacate (void) the SEC’s order.  Many of Citadel’s arguments—mainly that the SEC overlooked inaccuracies in IEX’s filings, disregarded data which contradicted IEX’s submissions and failed to conduct its own independent analysis--are unlikely to gain much traction with the court.
One issue Citadel raised, which is central to its case, is more interesting: that the IEX proposal, by design, unfairly tilts the playing field in favor of those who post orders to the detriment of those who seek to trade with such orders. By repricing posted orders, while intentionally delaying inbound orders seeking to trade with those posted orders at their displayed prices, the new price would be worse for the parties seeking to trade. In claiming to represent the interests of countless retail investors, Citadel offered the following analogy:
To put it in practical terms, imagine a grocery store that has deliberately installed extra-long conveyer belts on a checkout line. After you’ve committed to buy your items at the advertised price by placing them on the belt, the store uses the extra time required to traverse the belt to determine whether any item that was available at the same price at competitors’ stores had sold out. If so, the store’s computers quickly raise its own price before your item reaches the cashier. You can either pay the higher price or try to find the item elsewhere. (emphasis supplied).
Citadel has a point. While CQI is only activated for brief periods during the day, the only times the D-Limit order does not behave like an ordinary limit order, once the CQI is triggered, traders may not get the execution they think they’re going to get. The SEC acknowledged that D-Limit orders would benefit liquidity providers and work to the detriment of some liquidity takers.
The question then is whether this claimed harm to market participants should be fatal to the rule. The SEC didn’t think so, and an appellate court likely wouldn’t either. On closer inspection, Citadel’s argument looks less persuasive.
While Citadel suggested that the victims of the rule would be ordinary investors relying on quoted prices of resting limit orders, IEX’s submission showed, and logic dictates, that if CQI works as intended, most of the orders that arrive during the period of price instability which triggers CQI are placed by high-speed traders like Citadel which are deploying their latency arbitration strategies. In other words, evidence in the record showed, and the SEC determined, that the most likely “victims” of D-Limit orders would be Citadel and others employing latency arbitrage, the very target of IEX’s rule proposal.
But won’t other market participants be harmed as well? Likely, they will be. The ultimate question for the SEC, and now for the court, was whether this discrimination is unfair to traders and poses a burden on competition that does not further the purpose of the Securities Exchange Act of 1934. The SEC plausibly concluded that, where a small number of traders would be disadvantaged, the benefits of a narrowly tailored rule that generally promotes investor protection and transparency, and encourages liquidity providers to post limit orders on the exchanges, and thereby contributes in a meaningful way to price discovery, justifies the attendant harm.
The comments in favor of the IEX proposal came from a broad swath of the financial community—the Council of Institutional Investors, Vanguard, Goldman Sachs—and an unexpected source, Virtu Financial, a high-speed market maker, which argued: “In leveling the playing field, D-Limit will result in fairer, more competitive, and more efficient markets, and will enhance execution quality for investors.”
Citadel and Virtu are in the same business. It’s hard to imagine either one is actually the champion of the retail investors Citadel claims will be the victims of D-Limit orders. So what is it that explains the polar opposite approaches they take? Maybe one recognizes that it’s just not politic to oppose a rule aimed at fostering fairness in the financial markets in a case with limited prospects for success on the merits.
Whatever the motivation, what remains to be seen is whether this new order type will add value by providing traders with a means to compete with the Citadels of the world which can afford the infrastructure necessary to benefit from latency arbitrage.
 Securities and Exchange Commission, Release No. 34-89686 (Aug. 26, 2020).  Citadel Securities LLC v. Securities & Exchange Commission, Case No. 20-1424 (D.C. Cir. Filed April 12, 2021).  See Timpinaro v. SEC, 2 F.3d 453, 456 (D.C. Cir. 1993).  Letter of January 16, 2020 from Virtu Financial to SEC.