Citadel Securities is sometimes dismissively referred to as "Citadel's trading arm" -- seen as a forgotten backwater of Ken Griffin's hedge fund empire, where quants toil on complex algorithms to arbitrage tiny differences in stock prices or calculate bid-ask spreads for Treasuries.
It's much more than that.
The market-making firm, which is actually separate from Griffin's hedge fund, generated $3.5 billion of revenue last year -- vastly outpacing nonbank peers and catching up with Wall Street rivals.
Griffin, 51, earned about $870 million from his hedge fund in 2018, itself a stunning payday that funded a remarkable appetite for high-end real estate and philanthropy.
Citadel Securities may be even more lucrative -- with profit margins that he has previously said should exceed 30%. His wealth, long estimated at about $10.3 billion, based largely on his investments in, and ownership of, the hedge fund business, is $5.1 billion higher, according to new calculations by the Bloomberg Billionaires Index. That vaults him to No. 86 on the ranking of the world's 500 richest people, up from No. 150 at the start of this week.
Zia Ahmed, a Citadel spokesman, declined to comment on Griffin's net worth.
Eight years ago, Citadel Securities was looking like a failed experiment. Griffin, seeking to take advantage of the disruption caused by the financial crisis, built a full-service investment bank that would compete with Wall Street by offering research, underwriting and mergers-and-acquisitions advice. The effort ended after about two years. Dozens of employees were dismissed as the firm focused anew on electronic trading.
Today, it's a money machine, muscling banks out of markets they once dominated. It succeeded by being leaner and more technology-driven than bigger competitors, but also by taking advantage of regulations that hobbled those rivals. It even attracted interest earlier this year from Blackstone Group Inc., which weighed investing in Citadel's hedge fund and market-making businesses. But those talks ended without a deal, people familiar with the matter said in October.
Citadel Securities started as a high-frequency market-maker in options before pushing into equities. Today, it dominates that realm, handling more than 1 of every 5 shares traded in the U.S.
In recent years, the firm expanded its offerings and global reach, operating in more than 35 countries. It's a top 5 liquidity provider in foreign exchange and also trades Treasuries, credit indexes, ETFs and interest-rate swaps.
It acquired a division of KCG Holdings in 2016, gaining a presence on the floor of the New York Stock Exchange, where it's now the largest market-maker, winning mandates from Uber, Spotify Technology and Virgin Galactic Holdings. The firm could be in line for more lucrative assignments as startups bypass traditional public offerings for so-called direct listings.
Citadel Securities grew out of Griffin's hedge fund business. That pedigree helped it expand and adapt as markets changed, said Larry Tabb, founder of Tabb Group, a capital markets research firm. Making money in high-frequency trading was initially all about speed, but that arbitrage opportunity has become much more limited. While understanding where prices are in different markets is important, traders need to predict where prices are going.
"Getting faster is expensive, but it's actually kind of easy," Tabb said. "It's much more difficult to become smart. The hedge fund lineage helps with understanding some of the relationships and nuances and portfolio theory a little differently than traditional market-makers that don't have that investment background."
Technology has fueled the rise of nonbank market-makers, according to Tabb. Their smaller size and highly targeted business models make it easier to respond to changes and improve technology.
"While the banks tend to have big scale," he said, "it's really difficult for them to be as agile as some of the smaller guys, to pivot and to update infrastructure."
The rise of Citadel Securities also has been helped by regulations meant to reduce risk in the financial system.
One example is the Volcker rule, a provision of the 2010 Dodd-Frank Act that was designed to restrict proprietary trading by banks, though not their market-making activities.
But the rule named for former Federal Reserve Chairman Paul Volcker created uncertainty because "market-making from the bank perspective was very difficult to define," said Nathan Dean, a Bloomberg Intelligence analyst. Banks "didn't want to go too far to be seen breaking the rule."
Volcker probably resulted in nonbank dealers "permanently displacing" banks in the corporate bond market, according to a working paper published in August by the U.S. Treasury Department's Office of Financial Research.
A separate Dodd-Frank rule that pushed the clearing of swaps onto exchanges also helped Citadel Securities.
When swaps are traded bilaterally, the quality of a counterparty is important because its failure exposes its trading partner to the value of the swap. As a result, big banks capable of absorbing large losses were the preferred counterparties.
But when swaps are traded through an exchange, it's the exchange that takes on the risk, making the quality of the counterparty irrelevant while also improving price transparency.
Citadel Securities was one of the first nonbanks to push into markets that were opened up by the rule, said Kevin McPartland, head of market structure and technology research at Greenwich Associates. "That really made people more broadly start to pay attention," he said.
By targeting big banks, regulators hampered their ability to provide liquidity, JPMorgan Chase asset management chief Mary Erdoes said last year at the Bloomberg Global Business Forum, where Griffin was a guest.
They've been replaced by firms like Citadel Securities that are less regulated, and the market doesn't yet know if they'll be reliable partners in a crisis, she said. "It will be a very different playbook when we go through the next liquidity crunch."
In response, Griffin said his firm was well positioned to provide liquidity because it captures and processes data better than banks, allowing Citadel Securities to offer prices with more confidence during times of market stress.
The exchange highlighted a sometimes difficult relationship between Citadel Securities and big banks.
Citadel was part of a group of investors and market participants that won a $1.9 billion settlement from some of Wall Street's biggest financial institutions after alleging that the banks had conspired to limit competition in the credit-default swaps market and sabotage a CDS exchange planned by Citadel and CME Group Inc.
The banks were accused of agreeing to boycott the exchange as long as Citadel was involved.
Griffin hasn't shown much sympathy for the competition's woes.
"The disruptive innovation that has taken place within the equities market has created winners and losers," he said in written testimony for a 2014 hearing of the Senate Banking Committee. It shouldn't be a surprise that legacy participants "publicly yearn for the old days when they extracted disproportionate rents from investors on the basis of anti-competitive business practices," Griffin added.
The regulatory overhaul that followed the financial crisis created a more level playing field, said Ahmed, the Citadel spokesman.
"This transformation of the markets has resulted in more liquidity, better pricing and lower transaction costs for end investors," he said.
Market-makers pay rebates to brokerages for routing them retail client orders, which tend to be the most profitable trades because they carry the least risk.
Citadel Securities has been among the most aggressive in using rebates to win retail orders. Some market participants say the payments promote conflicts of interest and should be banned, but others say they improve order execution for retail investors.
In 2017, the firm agreed to a $22.6 million settlement with the Securities and Exchange Commission over allegations that it had misled clients over a small portion of trades in its high-frequency equities business. That didn't slow it down much. Citadel Securities now controls about 40% of U.S. retail equity market share.
The growth of Citadel Securities is even more remarkable considering its history of management turnover.
In 2008, Griffin hired former Merrill Lynch & Co. executive Rohit D'Souza to run the firm, but he left after a little more than a year. His replacement, Patrik Edsparr, who had been brought in from JPMorgan, lasted just seven months.
Then in July 2016, with great fanfare, Griffin handed the job to former Microsoft Corp. operating chief Kevin Turner. But his unfamiliarity with the world of finance came through during client meetings, where his management cliches and business-book catchphrases led to some uncomfortable encounters, Bloomberg reported at the time. He was gone shortly after the start of the following year.
Turner's successor, Peng Zhao, who's about to finish his third full year on the job, has brought stability. Zhao, 36, was plucked from his position as chief scientist to become CEO and is effectively a Citadel lifer, having worked there for 13 years.
Zhao is managing a substantially bigger company than when he started. Citadel Securities now employs about 700 people, up from 400 two years ago. Head count at the hedge fund has increased roughly 10% in the same span.
At Citadel Securities, there are no investor funds, so the efforts of its employees primarily benefit those who own the business.
Last year, helped by increased volatility, their labors produced gross revenue of $5.7 billion, which excludes certain trading expenses. That resulted in $2.2 billion of earnings before interest, taxes, depreciation and amortization, compared with $524 million for Citadel LP, the entity that houses the hedge fund. Griffin owns at least 75% of both businesses.
Of course, employees also have investments in the hedge funds, so they benefit when the funds perform well. A memorandum tied to a recent bond offering shows that about 20% of Citadel LP's $32.2 billion of assets under management come from principals and employees. Griffin has about $5.4 billion invested in Citadel funds, according to the Bloomberg Billionaires Index.
For now, those investments are thriving. The flagship Wellington Fund posted returns of 13% in 2017 and 9.1% in 2018, and is up 16.7% through the first 11 months of this year. That performance stands out in a challenging environment for hedge funds. Louis Bacon's Moore Capital Management, founded two years before Citadel, was one of the latest victims. Last month, it announced plans to close flagship hedge funds to outside investors and return cash.
Total income from the hedge fund business, including investment returns for its owners, exceeded earnings from Citadel Securities before 2018 and probably will again this year, according to a person with knowledge of Citadel's results.
Still, the securities business continues to expand rapidly and is now vying to become one of the Fed's primary dealers. These select firms trade directly with the New York Fed as it implements monetary policy, and they're required to participate in U.S. Treasury auctions. Such a move might invite fresh scrutiny.
Last year, at the CNBC Institutional Investor Delivering Alpha Conference, Griffin was asked whether his firm had become too big to fail. He pushed back.
"If we weren't there," Griffin said, "the market would clearly function, and function in a competitive manner."
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Bloomberg's Annie Massa, Katherine Burton and Sally Bakewell contributed.