By SCOTT PATTERSON
As the stock market spiraled out of control two weeks ago, two major firms that handle trades for retail brokerages suffered trading breakdowns.
One, the big Chicago hedge-fund firm Citadel Investment Group, stopped taking orders for a number of securities, according to an internal email and people familiar with the matter. Shortly after the market plunged, Citadel asked clients, including discount brokers such as E*Trade Financial Corp. and TD Ameritrade Holding Corp., to route orders elsewhere.
Citadel's technical glitch, as well as woes at another firm that trades for retail brokers, Knight Capital Group Inc., show how some everyday investors unknowingly were caught up in the market maelstrom.
Citadel Execution Services, the hedge-fund outfit's arm that makes markets, is one of the biggest players in executing trades for retail customers, from day traders to mom-and-pop online investors, executing and routing half a billion shares a day, according to its website. Citadel also ranks second among firms that provide liquidity on the Nasdaq Stock Market, the Nasdaq website says.
While it remains unclear what effect Citadel's problems had on the market, its move is emerging as another example of a tripped wire in the market machinery on May 6.
Knight was handling so many orders that one of its computers "just blew up," according to a person familiar with the matter. The breakdown led to a slight delay in handling orders and affected less than 1% of the firm's orders, the person said.
The Dow Jones Industrial Average fell almost 1000 points within minutes that afternoon, before rebounding.
Market participants, exchange officials and regulators trying to piece together the day's events have so far identified a number of possible contributors, including heavy selling of futures contracts, a withdrawal of high-frequency traders and conflicting practices on different exchanges.
The problems at Citadel and Knight may reveal another piece to the puzzle. Their breakdowns could have strained a market already overloaded by an explosion of trading volume, possibly causing disorder to spread, interviews with market participants and exchange officials suggest.
Discount brokers said several trading venues they use experienced problems during the turmoil but that they didn't disrupt clients' ability to trade. "There were a number of different destinations that we had to reroute" orders away from, said TD Ameritrade spokeswoman Kim Hillyer.
"There were strains in the system," said Greg Framke, E*Trade's chief information officer. "If there were issues, we were dealing with them."
At about 2:45 p.m., Citadel encountered problems with its order book that handles exchange-traded funds listed on NYSE Arca, the electronic exchange of NYSE Euronext Inc., according to a Citadel email to customers reviewed by The Wall Street Journal. Exchange-traded funds, or ETFs, are securities that trade on exchanges that represent a basket of stocks, for example tied to a sector or index.
At 2:57 p.m., Citadel sent the following email to clients: "We are currently experiencing Equity system issues. We are advising clients to please route away."
About a half-hour later, Citadel started taking some order flow back from clients who were experiencing trouble at other trading venues, according to a person familiar with the matter. The next morning, Citadel sent an email notifying clients its systems "are operating normally."
Under an agreement known as "payment for order flow," Citadel pays clients such as E*Trade and TD Ameritrade a tiny fee for shares routed its way. In the first quarter, it paid TD Ameritrade less than 0.15 cent a share on average, according to TD Ameritrade's SEC filings. For trades in which customers didn't specify a routing destination, Citadel handled more than a third of orders for NYSE-listed stocks for TD Ameritrade and E*Trade in the first quarter. Citadel owns about 27% of E*Trade's shares.
Other firms, including Citigroup Inc. and Knight Capital, also pay for order flow from retail brokers. The firms make money by taking the other side of the trade and flipping for a profit. For instance, if a customer of E*Trade submits an order to buy a stock for $10, a market maker could purchase the stock elsewhere in the market for $9.90 and sell it to the investor for a 10-cent profit.
The problems at Citadel also highlight the disproportionate impact the May 6 turmoil had on ETFs. Nearly 70% of trades that were cancelled following the plunge were in ETFs, according to a May 18 report on the events by the Securities and Exchange Commission and the Commodity Futures Trading Commission.
"ETFs as a class were affected more than any other category of securities," the report said.
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