Citadel Builds Swaps Unit to Repeat Market-Making TriumphMiles Weiss
Ken Griffin, the billionaire hedge-fund manager who’s captured almost 20 percent of trading in equity options through his market-making business, is taking aim at the global swaps industry.
Citadel LLC, the parent of Griffin’s money-management and brokerage firms, is setting up a dealer to make markets in contracts used to hedge or speculate on everything from currencies to corporate creditworthiness, according to a regulatory filing and a person briefed on the matter, who asked not to be identified because the plans are private. The move positions Citadel to compete with JPMorgan Chase & Co. and other banks that reap tens of billions of dollars in annual revenue from over-the-counter derivatives.
When regulators permitted the first fully electronic options exchange to start more than a decade ago, Chicago-based Citadel used its technological edge to become one of the largest market makers in both stock and equity-options trading. The firm now sees an opening in the swaps market as rules put in place after the 2008 financial crisis to promote transparent pricing, central clearing and electronic trading transform a business long dominated by a group of 16 international banks.
“If the market evolves in a way where the most important factor goes from relationships to technology, that is what the new entrants will thrive on,” said Ryan Sheftel, head of e-commerce in the fixed-income division of Credit Suisse Group AG. “If it goes very electronic, relationships matter less.”
Katie Spring, a Citadel spokeswoman, declined to comment on the new unit.
Griffin’s firm was planning to start quoting prices for interest-rate swaps and to provide liquidity through trading platforms being set up under the 2010 Dodd-Frank Act, he told Risk Magazine in August 2012. The Commodity Futures Trading Commission began requiring that some interest-rate swaps trade on these swap-execution facilities, or SEFs, in February, with several exemptions to the rule expiring last month.
Citadel in March incorporated Citadel Securities Swap Dealer, about the same time it hired Yanfeng Chen from Credit Suisse Group AG, where he focused on market making as a director of interest-rate swap trading. Chen, who earned a Ph.D. in mathematics from University of California at Berkeley, developed and managed an electronic swap-trading platform and a high-frequency automated trading system.
Used by corporate borrowers to convert floating-rate loans into fixed and by institutional investors to bet on economic growth and central bank policies, interest-rate swaps comprise the bulk of the market. With $584 trillion of such contracts outstanding as of December, according to the Bank for International Settlements, the market ranks only behind that of foreign exchange in size.
“The second-largest marketplace in the world is faced with a massive disruption,” said James Cawley, the founder and former chief executive officer of Javelin Capital Markets LLC, one of 24 SEFs that have signed up with U.S. regulators. “With disruption, there is opportunity.”
Credit Suisse estimates that the portion of swaps trading handled electronically has risen to 20 percent from 8 percent before SEFs, according to Sheftel. Bloomberg LP, the parent of Bloomberg News, is also among the companies that have registered a facility.
Since the financial crisis, global regulators have sought to avoid future bank bailouts by requiring that the companies hold more capital against losses, reduce leverage and, in the U.S., stop using their own money to make proprietary market bets under the so-called Volcker Rule. The moves have raised costs for banks, prompting many to shrink their balance sheets and step back from making markets in bonds.
These trends have also played out in the swaps market, where clients have traditionally worked the telephones or used instant messaging to solicit quotes from dealers, formerly a group of 16 international banks that ex-CFTC Chairman Gary Gensler once labeled the G-16. The banks’ balance sheets, credit ratings and ability to offer loans and other services appealed to potential clients who planned to hold the contracts for years and wanted to minimize the risk that an agreement’s counterparty would default.
The new rules from the CFTC and the U.S. Securities and Exchange Commission are designed to increase competition and allow market participants such as hedge funds and oil companies to vie with the banks in displaying offers to trade the contracts.
So far, would-be competitors have been waiting to see whether they must register as dealers under the new rules, a designation that imposes additional requirements on firms that hold themselves out as market makers for swaps or whose trading exceeds minimal levels, said Michael Philipp, an attorney in the Chicago office of Morgan, Lewis & Bockius LLP.
“A lot of people are saying banks are running out of the OTC derivatives market like it is a burning building,” said David Weiss, a senior analyst at research firm Aite Group LLC. “Citadel is signaling that this is a good time to put your money down and make markets.”
Citadel has been laying the groundwork to enter the swaps business ever since Dodd-Frank was enacted in July 2010. Starting that December, Randall Costa, then-operating chief of the technology group, and Adam Cooper, the firm’s top legal officer, held more than 30 face-to-face and telephone meetings with the SEC and the CFTC, according to the agency websites.
The firm joined with Getco LLC and others to push regulators to adopt a central-clearing process for swaps. With the establishment of central clearinghouses, all of the dealers that wrote swaps would commit billions in cash and securities to protect against default of any one contract, allowing smaller entrants to compete with banks on price rather than size and credit rating.
Central clearing “eliminates any balance-sheet advantage of large dealers that are perceived to be ‘too big to fail,’” Citadel said in a written presentation for a January 2011 meeting with the SEC. New competitors can provide liquidity as executing brokers, the firm said, leading to a further reduction in the spread charged by dealers.
Technology has been a key tool for Griffin, 45, ever since he wrote a computer model to price convertible bonds upon founding his first hedge fund in 1987 during his sophomore year at Harvard University in Cambridge, Massachusetts. About 400 of Citadel’s 1,100 employees work on the technology side, focusing on such tasks as developing risk-management systems and writing algorithms that guide quantitative trading.
The firm runs hedge funds through Citadel Advisors LLC, which had $16 billion in net assets under management at the end of last year. The Citadel Securities unit, an SEC-registered broker-dealer, engages in proprietary trading and provides securities-lending services to its sister hedge funds along with making markets in U.S. options and equities.
When Citadel joined the International Securities Exchange in May 2002, the options business was undergoing some of the same changes now reaching the swaps industry. Trading was characterized by low volumes and wide dealer spreads, with most of the action occurring on the floor of established venues such as the Chicago Board Options Exchange and the American Stock Exchange.
Less than three years later, Citadel had taken more than 10 percent of the daily trading volume in U.S. listed equity option contracts, and as recently as October, the firm controlled more than 19 percent, according to letters it has submitted to the SEC. With the advent of an all-electronic market, spreads narrowed and trading volumes soared, giving firms such as Citadel an edge.
“It was a small market with very few options being traded because of the costs, but the dealers made big money,” William Porter, the retired co-founder of the ISE and E*Trade Financial Corp., said in a telephone interview. “The trade-off came about when they traded a kazillion number of options at a very low price and made very good money.”