Citadel To Handle E*Trade's Lucrative Order Flow

Last week I posted about Citadel's investment in E*Trade (ETFC). Subsequent to the investment, ETFC has been rated a sell by BofA and the stock is currently trading below Citadel's buy price. Sort of.

Something unmentioned in the news reports of the deal, but available here (Item 1.01, paragraph 7) is that 40% of ETFC's equity order flow and "substantially all" of its customer option order flow will go through Citadel's execution business (tip of the hat to hedgeworld.com). Now, Citadel is a very well known hedge fund, but less well known is its execution and market making business. Citadel's derivatives trading group is one of the largest option market making groups in the whole business, right up there with Goldman Sachs (naturally). Citadel will profit in at least three ways from the equity and option order flow:

• Capturing the bid/ask spread on the order flow they trade themselves.
• Receiving payments for order flow from other liquidity providers on the option orders they don't want to trade.
• Using the information advantage of knowing retail order flow.

It's pretty easy to model the value of the first two, once you know average spreads and average volume. Absent knowledge of Citadel's strategies and processes, measuring the value of the third is impossible for an outsider. Suffice to say, it's huge.

So, the $2.5B that Citadel is investing is hedged by the interest payment, the preferred claim on assets in bankruptcy, the fire sale purchase price of the ABS portfolio, the potential trading profits, the brokerage revenue, the market intelligence and a seat on the Board of Directors. Well done, Ken Griffin.

Comments

[etfc whiz]

This is just part of Citadel's strategy to become the investment bank of the internet era. It thus further supports the idea that Citadel is banking on ETFC growing dramatically. Order routing isn't very useful to them if there aren't a lot of orders to route.

[jswede]

I agree with the first part, whiz, but I don't think Citadel is necessarily counting on ETFC. Through this deal, they are positioned incredibly if ETFC fails in a few years (20% equity stake - most of which was a gift thru the deal, $1.5bil loan which is senior to all other debt after the 2011 bonds mature, not to mention the ABS portfolio they stole).

The order routing is something they want to bring into the fold alongside their (huge) CDS and derivatives trading businesses to become that i-bank of the future. IIRC, Citadel does (or has plans to) market their back-office expertise, capabilities and trading platforms, which all fits into that plan you mention.