What's Behind Virtu's 22% Gain After Year-Long IPO Delay

NEW YORK (TheStreet) -- Just over a year ago, Michael Lewis's expose on high-frequency trading, Flash Boys, was sparking debate on Capitol Hill and Wall Street, prompting critics to claim that markets are rigged.

Virtu Financial, a high-frequency trading firm planning to go public at the time, backtracked amid increased scrutiny from regulators and politicians. Today, however, the company has successfully completed its initial public offering and climbed 22% since shares began trading on April 15. Total revenue increased 52% to $645 million in the three years through 2014, and four of seven analysts surveyed by Bloomberg have a buy rating on the stock.

Investors appear impressed by the New York City-based electronic market maker's ability to tap into markets across a broad swath of industries in 34 countries. Virtu's business model is essentially to quickly buy and sell a range of securities and take advantage of the small resulting changes in bid-ask spreads, the prices at which buyers and sellers simultaneously are willing to make trades.

"What is unique about Virtu is that they are diversified across asset classes and geography," said Richard Repetto, an equities analyst with Sandler O'Neill. "They are able to take advantage of many different markets with different instruments."

Virtu's chairman, Vincent Viola, is no stranger to multiple asset classes. As a former chairman of the New York Mercantile Exchange, he distinguished himself as an expert in both electronic trading expert and the esoteric derivatives and strategies that are routine in commodities trading.

Virtu's main strategy to capture price volatility is not its ability to trade quickly, but the ability to access market turbulence with such a broad scope, CEO Douglas Cifu said on the company's first earnings call in May.

"As we've repeatedly said, the core strength of this firm is the diversification," he said. "We're there to capture those periods of episodic volumes and volatility where they may arrive."
 

 
Diversification is a more useful tool than event-driven modeling, said Cifu, who explained that company analysts don't focus on projecting "moments of volatility and periods where crude goes from $40 back up to $60 and $100 to $40.
 
"Those types of events are very difficult for us to model out," he said.
 
Virtu is connected to about 225 market venues and trades more than 11,000 financial instruments. The company brought in $148 million in net income in the first quarter, benefiting from higher volatility in the currency and energy markets. 

"Virtu was consistently profitable throughout the quarter, including during some notable events, which contributed to overall volatility and volume, such as the Swiss National Bank related events and the sustained volatility in the U.S. and European equity and global energy markets," Cifu said. "These market events also demonstrate the robustness of our risk system, as we were able to make markets through these volatile events without incident."

Risks remain, however. Potential SEC regulations and federal litigation could hamper the way the company places orders for securities, especially in companies with low market capitalization that tend to gyrate more wildly.
 
"Firms in the financial services industry have been subject to an increasingly regulated environment over recent years, and penalties and fines sought by regulatory authorities have increased considerably," Virtu noted in its registration statement in March. "Following recent news media attention to electronic trading and market structure, this regulatory and enforcement environment has created uncertainty with respect to various types of transactions that historically had been entered into by financial services firms and that were generally believed to be permissible and appropriate."
 
High-frequency trading, in particular, continues to be "the focus of extensive regulatory scrutiny by federal, state and foreign regulators and self-regulatory organizations, and such scrutiny is likely to continue," the firm said.
 
In February, for example, the New York Stock Exchange proposed a "midday auction," which would tighten the window of time available to buy thinly traded companies, in an effort to reduce spreads. Such companies are major arbitrage opportunities for Virtu.
 
"If adopted, the new rule could result in reduced opportunities for liquidity providers," the company said in an April filing with the SEC, "while reducing spreads during the midday auction."
 
One Congressional strategy to curb high-frequency trading, which has been said to hamper financial markets by not serving an actual economic function, is a minor tax on individual market orders, proposed earlier this year by Rep. Chris Van Hollen, D-Maryland.
 
"As financial observers have pointed out, the profits currently being pocketed by front-running high-frequency traders already amount to a kind of hidden trading fee on ordinary investors," Van Hollen said in the  January proposal. "A properly structured financial market trading fee would put an end to much of this economically counterproductive activity and replace it with a source of revenue to pay for middle-class tax relief."

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