Citadel’s E*Trade Bonanza

August 14, 2009

Citadel Investment Group’s move to aggressively sell off its substantial stake in E*Trade Financial looks like hedge fund magnate Ken Griffin is throwing in the towel on his big gamble on the online broker.

But Citadel isn’t bailing on E*Trade. In fact, if Griffin gets his way, the Chicago hedge fund will have its fingers dug deeper into E*Trade, getting daily access to virtually all of the online broker’s stock and option trades.

With little fanfare, Citadel and E*Trade struck a tentative deal in June that would require the online broker to begin routing 97.5 percent of its customers’ Nasdaq stock and stock option trades to the hedge fund’s market-making operation.

Right now, E*Trade sends about 40 percent of its customer trades to Citadel’s market-maker division under a nearly two-year-old agreement that dates back to the hedge fund’s initial $2.5 billion investment in the broker.

This new exclusive six-year arrangement would mean even bigger bucks for Citadel’s already highly-profitable high-frequency trading business, given that E*Trade customers make more than 4 million trades a month.

Indeed, the deal is so potentially lucrative for Citadel that the hedge fund is willing to make an upfront $100 million cash payment to the financially-strapped online broker.

E*Trade’s regulator, the Office of Thrift Supervision, must approve the deal before it can take effect. And there are indications the OTS is about ready to give the deal the green light — possibly as soon as today.

(UPDATE: Scratch that. The OTS late Friday suspended consideration of the application, meaning Citadel’s plans are on hold.)

The OTS’ decision make sense because this was a case where the OTS should go slow and take its time, given all the recent controversy focused on high-frequency trading — a lightning-fast strategy in which computer-driven algorithmic programs buy and sell stocks, options and commodities in milliseconds.

There’s been a lot of justified concern about whether high-frequency traders are getting an unfair price advantage by buying and selling stocks a split second ahead of the rest of the pack.

Others worry about the potential for a so-called “rogue algo” sparking an out of control computer-driven sell-off that could rival the 1987 market crash.

Another real concern is that just a small select group of Wall Street investment firms and hedge funds — Citadel, Goldman Sachs, UBS, GETCO, Interactive Brokers and Wolverine Trading, to name a few–dominate the market for high-frequency trading.

In the options world, Citadel’s market-making division, Citadel Derivatives Group, is the big kahuna. Its high-frequency trading-powered desk controls some 30 percent of the daily trading activity.
So if this exclusive pact with E*Trade goes through, Citadel’s stranglehold on the options market will simply get a bit tighter.

Now to be fair, Citadel, which declined to comment, likes to point out that its market-making business is distinct from its proprietary high-frequency trading business.

Citadel says it’s wrong then for anyone to accuse the hedge fund’s proprietary high-frequency traders of taking unfair advantage of E*Trade customers or those of any other broker that routes trades to Citadel Derivatives Group.

But in the high-frequency game it’s all about getting as much customer “order flow” as possible. That’s because the algorithmic programs that drive high-frequency trading desks, both for market-makers and prop desks, are designed to anticipate trends in prices of stocks, options and commodities.

The more trades these sophisticated machines get to see, the better they become at predicting price trends and making money for their creators. And often the same top secret algos that drive Citadel’s market-making business also help drive its prop trading too. Just like people, computers talk to each other.

“Your computers can build better models with more order flow and you change the odds just a little better in your favor,” says high-frequency trading critic Joseph Saluzzi, a co-founder of the institutional brokerage shop Themis Trading. “It’s just like a casino.”

And at a casino, the house usually wins.

UPDATE: Sometimes the casino loses. The OTS, late Friday, showed some moxie and decided to “suspend consideration of the application while we examine certain issues,” according an OTS spokesman. William Ruberry, the OTS spokesman, declined to elaborate on the regulator’s action. He added that a confidential “policy and law” letter about the decision to suspend the application had been sent to the parties.

One can speculate the OTS has taken the recent concerns about HFT trading heart and wants to get more information about Citadel’s plans. This action, also means, the Etrade won’t be getting that extra $100 million payment from Citadel.

The OTS is an oft-criticized regulator. But this time they appear to have gotten things right.


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