E*TRADE and Citadel

[txlaw]

Any holders of ETFC on the board? 

 

If so, any opinions on why Citadel is selling some of the shares it currently owns into the market?  My understanding is that Citadel's effective ownership will still be quite high based on the shares they keep and their position in ETFC's convertible debt, so that might be one explanation.

 

Also, Citadel has been criticized for saving ETFC in order to access ETFC's order flow for its high frequency trading operations.  Can anyone explain to me what the difference is between market making, "front running", and high frequency trading?  I'd like to get some clarity on what's really going on here.

[link01]

<<Can anyone explain to me what the difference is between market making, "front running", and high frequency trading?  I'd like to get some clarity on what's really going on here.>>

 

thats a great question. very easy for the lines tp get blurred at the intersection of these 3.

[txlaw]

Can anyone explain to me what the difference is between market making, "front running", and high frequency trading? 

 

Anyone . . . anyone?  Bueller . . . Bueller?

[T-bone1]

I believe market makers are regulated, or at least officially designated in those stocks in which they make a market. I think they are required to make a two sided market for at least 100 shares on each side, kind of like a specialist of old but without the requirement to use their own capital to keep an orderly market.

 

Front running is placing a buy or sell order ahead of a large buy or sell order you have knowledge of. Major Wall Street firms are occasionally caught doing this, buying for their own account ahead of large mutual fund orders for example. The specialist firms, which recieved privaleged non-public information on order flow (in exchange for using their own capital to preserve an orderly market) routinely front ran their clients in both legal and illegal ways. I believe there was a large settlement for all of the illegal front running they did for years.

 

High Frequency Traders use a number of strategies, some of which are probably illegal front running (which has been put to a stop over the last few days and weeks I think), some of which are technically legal but still abusive and predatory front running, and others that I don't quit understand. The blatant front running they were engaged in involved "flash orders", where brokers or ECNs would show them orders for a few milliseconds (a flash) to see if they wanted to fill the order, otherwise it went to the exchange. Because HFT's have computers physically located at the exchange, if they don't fill these orders, they can still front run them because they can get an order into the exchange before the original order gets there. They also probe the market with quick hundred share orders at different price points to sniff out large institutional orders using algorithms to slice and dice the order into smaller pieces. Since they know how this works, when they find a big order like this they front run it.

 

There is a blog called zerohedge that covers all of this in much greater depth, but suffice to say that high frequency traders take a lot of money out of the market without investing in anything (making them a predatory money drain) and they don't have to provide liquidity if they don't want to (which was the service specialists provided in return for the right to be a generally predatory money drain on the market).

[txlaw]

Great explanation -- thanks, T-bone! 

 

I will check out Zerohedge to get some additional color on the HFT issue.

[txlaw]

If so, any opinions on why Citadel is selling some of the shares it currently owns into the market?  My understanding is that Citadel's effective ownership will still be quite high based on the shares they keep and their position in ETFC's convertible debt, so that might be one explanation.

 

Well, Citadel has canceled their plan to sell their ETFC shares, and it looks like traders are speculating that there will now be an acquisition of the company facilitated by Citadel. 

 

Regardless of whether there is an acquisition, this is good news for investors in ETFC because the worst thing that will probably happen now is that Citadel infuses the banking subsidiary company with more cash in exchange for cheap stock.

[txlaw]

Some good FT articles on "flash trading":

http://www.ft.com/cms/s/0/5fbac920-81ea-11de-9c5e-00144feabdc0.html?nclick_check=1

http://www.ft.com/cms/s/0/35d54d32-812d-11de-92e7-00144feabdc0.html

 

Perhaps one of the silver linings of a tiered trading system is that more smaller players will drop out of the trading game and switch to investing.  Wishful thinking, I know!

 

It seems pretty clear now that Citadel has made an outstanding play by helping Etrade recapitalize.  Not only did they get a decent average cost basis for their position, but they could also potentially get a material bump in order flow for their market making operations.  It is also possible that Citadel is planning on analyzing this order flow to tweak their HFT algorithm, but it seems unlikely that they will use this information as flash order information -- I don't think they'd be that stupid given the firestorm surrounding the issue.

 

As for their quick reversal on selling some of their position, I wouldn't be surprised if OTC told Citadel not to go forward with this (Zerohedge also thinks this may be the case).  Doing so would put pressure on the market price of the company, which could make a material difference to the health of the company since Etrade may have to raise more equity capital if their loan portfolio deteriorates at a worse rate than expected.  And market price can also have an effect on financial companies' credit ratings, as we saw with the investments banks and insurance companies last year.  As an investor in ETFC -- I have now initiated a position -- I want at least a higher price than my cost basis for any new capital that is raised and would love for them to go the rights offering route in order to allay any concerns about the banking operations. 

 

I have been going through some of the old board posts and I have gotten to the point where there has been a flurry of activity related to the FFH short saga.  I am beginning to wonder to what extent shorts may be involved in information disseminated about ETFC.  Etrade has one of the highest short interests of any stock in the S&P 500, and I believe the short interest is close to 30% of the average daily float.  Thank goodness there has been a naked short selling ban put in place or ETFC may have plummeted when Citadel initially made its sale announcement.