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 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 the 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) 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.