Feb. 4 (Bloomberg) -- Citadel Investment Group LLC, the asset-management firm run by Kenneth Griffin, separated its hedge-fund business from an options market-making unit in what may be a prelude to a public offering.

Citadel Derivatives Group LLC, the options specialist, and an offshore fund that trades the securities were split off at the start of the year, according to a regulatory filing. The move may make it easier for Chicago-based Citadel to sell shares in either business and ease concern that its hedge funds profit from ties to the options market maker, according to Josh Galper, a financial-services industry consultant.

``Legally, it makes it cleaner,'' Galper, managing principal at Vodia Group LLC in a Concord, Massachusetts, said in an interview. ``No one wants to be in a position where there is a suggestion that a proprietary hedge fund is trading against the order flow of retail clients.''

Citadel, which oversees $20 billion and generated a 30 percent return last year, may consider an initial public offering as a ``byproduct of our wanting to expand our firm,'' Chief Financial Officer Gerald Beeson said in a BusinessWeek interview published Jan. 3. He didn't say whether Citadel might sell shares in itself or any of its businesses.

John Nagel, Citadel's deputy general counsel, said in an interview the changes were made for ``internal corporate purposes and efficiency reasons.'' Citadel has made similar organizational moves since 2000, Nagel said. He declined to comment on ``anything related'' to an IPO.

Citadel's Expansion

Och-Ziff Capital Management Group LLC, the New York-based hedge-fund manager run by Daniel Och, went public in November in a deal that valued the firm at $12.3 billion. The stock has lost almost 28 percent since the IPO. The firm oversees $30 billion.

Griffin, who started Citadel in 1990 after trading convertible bonds in his Harvard College dorm room, has diversified into markets such as currencies and commodities, and services for money managers such as back-office administration and securities lending. The spinoff was disclosed in a Jan. 18 filing with the U.S. Securities and Exchange Commission regarding Citadel's holdings in E*Trade Financial Corp.

Hedge funds such as Citadel originally became market makers to gain a ``time and place advantage'' over other customers in trading, according to David Mortimer, chief executive officer of 3D Markets Inc., a New Hope, Pennsylvania-based firm that runs an electronic options-trading system. Market makers that clear transactions through a major brokerage such as Merrill Lynch & Co. or Goldman Sachs Group Inc. also get to use more leverage when trading.

Options Trading Increases

Options, which provide the holder with the right to buy or sell an asset or security in the future at a set price, trade on exchanges and through private transactions. The exchanges have options listed on assets and benchmarks ranging from stocks and stock market indexes to currencies, corporate credit ratings and interest rates.

Trading in the $1.3 trillion U.S. options market grew last year at its fastest pace since 2000, as more hedge funds and institutional investors turned to derivatives to boost returns. Interactive Brokers Group Inc., a publicly traded electronic market maker and broker in Greenwich, Connecticut, and affiliates reported that net income rose 21 percent to almost $886 million last year.

E*Trade

Citadel Derivatives Group said it routes options orders to all six options exchanges on behalf of 20 retail brokerage firms. It and Interactive Brokers are the two largest options market-makers in the U.S., according to Richard Repetto, an analyst at Sandler O'Neill & Partners LP in New York. Citadel has said its combined operations account for more than 20 percent of exchange-listed options trading in the U.S.

Citadel's market share is likely to increase under an agreement to pump $2.55 billion into E*Trade, the fourth-largest U.S. discount brokerage. That agreement calls for E*Trade to send all of its customers' option transactions to Citadel for the next three years.

The market-making unit was held through the hedge fund Citadel Wellington LLC until the end of last year. The offshore fund, Cayman Islands-based Citadel Derivatives Trading Ltd., was owned through Citadel Equity Fund Ltd.

Citadel disclosed that the two are now owned through Delaware-based partnerships that were incorporated in the second half of 2007, including CLP Holdings LLC, Citadel Derivatives Group Investors LLC and Citadel Tactical Trading LLC. As a result, the hedge-fund management and options market-making businesses are now held under two different parent companies, both of which are controlled by Griffin, the filing shows.

``I would suspect that this has something to do with compliance reasons,'' Mortimer said. ``Many of these hedge funds have spun out their market-making units into separate entities because they are dealing with public customers as exchange members.''

To contact the reporter on this story: Miles Weiss in Washington at mweiss@bloomberg.net

Last Updated: February 4, 2008 17:09 EST