Citadel Set to Control 97.5% of E*Trade's Order Flow

Ken Griffin's recent announcement that he is divesting a major portion of his E-Trade (ETFC) holdings presumably demonstrates a divergence of the paths of the two firms, while in fact Citadel is getting ever more intertwined with the online broker's operations, in fact giving the Chicago firm almost exclusive control over E-Trade's customer trade flow. Matt Goldstein at Reuters reports:

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.

Is this merely a way for Citadel's other divisions to have advance notice on the intent of a significant number of daytraders? Citadel claims no:

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.

Yet is it as black and white as all that? In order to get access to nearly double the order flow from E-Trade it currently sees, Citadel is willing to make an upfront $100 million payment to the brokerage that until 2 years ago was selling mortgages, whose resultant implosion left it on the verge of bankruptcy.

One would hope the OTS is carefully examining the implications of this transaction, for several very valid reasons:

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.

And as Matt concludes:

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.

Let's not forget that Citadel (along with Goldman Sachs (GS)) is a minority owner of Direct Edge, which is at the heart of the Flash trading scandal, and is the one firm that to date has refused to voluntarily ebolish Flash trades. Perhaps the OTS should figure out what informational advantage (if any) Citadel gleans from Direct Edge either directly or indirectly, and then decide on whether the proposed transaction is truly for the benefit of E-Trade's numerous customers.

Comments

[Stone Fox C...:]

Guess they got the deal they wanted and are now fleeing the investment in ET. Citadel evidently doesn't think the deal is that great for ET.

Aug 14 05:02 PM

[Robert Mart...:]

Zero Hedge nails it once again.

Clearly, Citadel wants signals from E*TRADE's order flow. This allows Citidel to use high-frequency-trading to fleece E*TRADE customers a penny on each order. Alternatively, Citadel can use signals from the order flow to front run customers, to improve the positioning of its own book, and to get proprietary data for its options business.

Yesterday Zero Hedge highlighted how this is done via dark pools and flash trading: seekingalpha.com/artic...

Moon Kil Woong pointed out another dark side to HFT: It distorts price and volume signals for the market, leaving investors and traders guessing as to what is signal and what is noise. His comment is here:
seekingalpha.com/artic...

Bottom line: HFT is not only used used by brokers to exploit their own customers, it is inflating order volume and distorting price signals. Trading volume during the current market rally is already thin, and subtracting HFT activity would make the rally look even weaker.

Kudos once again to Zero Hedge for investigative work.

Rob

Aug 14 05:47 PM

[Jon G:]

I stopped trading options on Etrade last year. I was trading options on the indicies and highly liquid but volatile stocks & consistenly found myself getting bent over for 1 or 2 cents on my options' market orders vs. real time prices. I complained several times to no avail.

Aug 14 07:39 PM

[Moon Kil Woong:]

How do you think discount brokers survive. It states very clearly on their contract they may act as the market maker for your trades and use your shares freely. Many of your trades never hit the exchange. many of your trades make hundreds of dollars in spread regardless of you paying almost nothing for a trade. And your stock is often loaned out for others to short.

Tthat is discount brokerages business model. It is this that works. What sunk E*Trade was using your money to speculate on property. Citidel's deal just highlights how much it is worth keeping trades off the exchanges and in your back pocket. At least it lowers their conflict of interest. However, I wouldn't expect getting a better deal. It looks like your oders will now go from something like a two bit bookie to well honed organized crime syndicate.

Aug 14 11:52 PM

[lower98th:]

Perhaps we should call flash trading what it is - a transaction TAX, paid not to the government, but to Goldman and company. It should be only a matter of time til the authorities grab this revenue source for themselves.

Aug 15 07:15 AM

[Maxe Paul:]

Anyone who is as well known as Ken, and has no picture published in their Wikipedia file, must be a shifty, sneaky, slimey charcter IMO.

I dont trust people like this.

Aug 15 09:09 AM

[Novice Trader:]

Wow (this article, along with all of the above comments) was a real eye-opener for me.

Thank you very much!

Aug 15 11:05 AM

[Wampeter, F...:]

It is a very good move on Citadels part. Many of Etrades customers dont have level 2 access to quotes and will put in less sophisticated bids. Seemingly, this allows Citadel to snap up those orders at less than competitive prices.

I wonder if you could show the losses suffered by Etrade customers because of that companies actions to give them less than adequate market access? Presumably that loss is at least $100 million dollars.

Aug 15 11:09 AM

[Bill L.:]

On Aug 15 11:09 AM Wampeter, Foma and Granfalloons wrote:


> I wonder if you could show the losses suffered by Etrade customers
> because of that companies actions to give them less than adequate
> market access?

Unfortunately I don't think E*trade customers will have much of a choice in the matter. All they can do is move their accounts to another discount broker that is going to act in a similar fashion. Furthermore on an individual level, I'm sure the losses are in the order of fractions of a penny per share.

It's not right, but then again if you're trading the markets you're going to get screwed once in a while no matter what.

Aug 15 02:03 PM

[Paul Harper:]

so, in retrospect, who is the most honest online broker out there ?

(a serious question btw)

Aug 15 02:59 PM

[kohalakid:]

I had two open limit orders on a stock that trades average 30,000 shares a day.

One order was to buy 2500 at 8.36. The order was at Etrade.

The second order was to buy 2500 at 8.30. That order was at Schwab.

Schwab managed to fill 1300 shares at 8.30 while I got nothing at Etrade.

Schwab seems to have consistently good execution. Etrade has been shaky at times.

Aug 15 03:53 PM

[LKofEnglish:]

actually when it really gets interesting is when wall street starts looking at the bid to ask spreak on treasuries and can't price the stuff. now there's a sandwich i wouldn't want to be between. hmmm. to be a primary dealer or not to be, that is the question. whether it is nobler in the mind...

Aug 15 04:56 PM

[SaBiN:]

Not much sense in using E*Trade I guess.

Aug 15 05:44 PM

[Chkrazer:]

Etrade is great for trading stocks BUT nothing beats optionhouse ... great price, great execution, great record keeping, tax analysis, etc.

Aug 15 08:17 PM

[sethmcs:]

Correct me if I am wrong but hasn't there always been market makers who have superior information to the individual trader and profit from the spread? How many here remember the bad old days of trading in 1/8s?

Aug 15 11:32 PM

[Yoon Kim:]

Front running is nothing new at Etrade. They paid $34M in settlements earlier this year after SEC charged them with front running 1999 - 2005 (www.reuters.com/articl...). Given SEC's 4-10 year lag time to bring about charges since crime is first detected, 2009 front running might not come to surface long after the casino bandits have made off with the loot.

Aug 16 01:09 AM

[Wampeter, F...:]

Re Bill L, I was mainly speaking off the cuff but if there is a loss suffered by the traders because the institution failed to properly make the sales at market price (which presumably is at least $100 million as stated before) then there is an argument that this practice is different than simply allowing market makers to take up on trades on the floor that are available to all.

I was just throwing it out there for contemplation as a class action but I havent looked into it at all and suspect there would be a whole bunch of reasons it would not succeed.

Personally I think it should be illegal because it goes against all precepts of setting up a fair market and I suppose that I was planting the idea more because the practice ought to be illegal since it is clearly used in a highly structured manner to distort the market place and skim profits and is contrary to the idea of a fair and efficient marketplace.

Aug 16 03:26 AM