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June 20, 2005

Citadel Wears Two Hats: As both Client and Market Maker

By Mark Longo

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  • Citadel Wears Two Hats: As both Client and Market Maker

For decades, they have been the cloak-and-dagger arm of Wall Street. These mysterious entities trade on behalf of secretive clients, devising elaborate strategies that move markets, and, in rare instances, cause markets to meltdown. Like most unregulated entities, they prefer to stay in the shadows, emerging on occasion to unwind or increase their positions. Every few years, one of these entities becomes so big that it can't help but draw attention to itself. Such was the case in 1998 when Long Term Capital's highly leveraged spread trading threatened to implode the global financial system.

The shockwaves from that near-disaster reverberated throughout the financial markets and focused the attention of regulators on the perceived shadowy world of hedge funds. The hedge fund industry world never be the same, and neither would the world of options.

Rogue Memories

Today, one would be hard-pressed to find a fund that refers to itself by the sinister title "hedge fund." The term carries with it far too many memories of the rogue funds of the late 90's. Instead, they now refer to themselves as "private investment funds," and their influence is being felt across a number of financial markets. Although most funds primarily trade equities, they were also among the first customers to understand the hedging power of options. Selling upside calls against stock positions has always been a popular trade in the hedge fund playbook.

However, over the past five years, the relationship between hedge funds and the options industry has evolved. "Six or seven years ago, the hedge funds were almost nonexistent in the options business due to the market's inefficiencies," says Ed Boyle, VP of Equity Derivatives at TD Securities. "Now they've built or acquired sophisticated technology while learning how to use options to decrease risk and enhancing returns. I've heard numbers that as much as 50 percent of our customer volume can be tied back to hedge funds."

Profit Center

Once seen as little more than a hedging tool, options have now become lucrative profit centers for many funds. So lucrative, in fact, that several funds have made the transition into options market makers. One of the largest funds to make the transition so far has been Citadel Investment Group, which has some $12 billion in assets.

"Three years ago, we made a decision to become options market makers instead of just options customers," says Matt Andresen, President of Citadel Execution Services and and the former chief executive of Island ECN. "The two main reasons for this were the increasingly competitive nature of the listings in the options markets and the increased efficiencies provided by electronic trading. We believe that the strength of these two trends will continue well into the future." Andresen is a trading big leaguer. Before Citadel he served as head of global trading at Sanford C. Bernstein for about a year. That was a position he took in the fall of 2002, passing up the chief operating officer job at Instinet after it bought Island. Andresen spurned Instinet because he thought Bernstein was a better career fit. Now he thinks options offer Citadel a better profitability prospect.