As excerpted from the case study, Deconstructing Citadel Securities
Alphacution believes that Citadel’s core competitive advantage – its secret sauce – can be found on display every day, out in the open, and is not related to a specific product, asset class, region or even a specific trading strategy or temporal wave of theoretical alpha. No, the thing that makes Citadel so unique is its focus on process. You just need to know what to watch for.
Everything this company does has first been disassembled and deconstructed down to its smallest, atomic parts and then reassembled with a maniacal sensitivity to details, best-practices and processing – whether that be a decision-making process or a data management process or a strategy launch process. In all activities front-to-back, this team seeks opportunities for efficiency and to catalog incremental intelligence at every step. And though the company has developed a stellar reputation for the application of technology to its workflows, it is only by virtue of the additional ingredients of culture and excellence in assembling human capital skills that the former can be applied in such impactful fashion.
So, with processing at its heart, Citadel has grown to be active in markets where it can establish persistent competitive advantages by consistently discovering and harvesting the value of information asymmetries, full stop. Secondary to this, Citadel displays a strong preference for markets that exist at the crossroads of high liquidity and high workflow automation. Because it is here, at this crossroad, that one can optimize the asset capacity-performance mix. Hence, we see a strong presence in cash and derivatives products in listed markets, which is essentially the core of their market making operation. Furthermore, Citadel will seek to become active in OTC markets that display strong symbiosis with listed counterparts, and even take a pioneering position in those markets that are in a state of transformation towards greater workflow automation, such as OTC swaps and swap futures.
As a counterfactual, we don’t detect any concerted effort to use the brand to establish positions in less liquid products or strategies with less automated (or automatable) workflows, like real estate or venture capital or perhaps distressed credit. This is not to say that Citadel has set a constitutional boundary to avoid making concentrated or illiquid trades. They do and they will, but not necessarily in the ways that you might expect. Watch who is the most decisive during the aftermath of market dislocations and you will discover which teams excel at data management and the harvesting of information asymmetries. Think about who moved with greatest agility to gather distressed trading books in the aftermaths of Enron and Lehman Brothers. In both cases, Citadel was a first-mover.
Furthermore, if the role of a product or market remains in question or the data flows tend to lack a level of credibility, those opportunities would tend to be avoided by Citadel. To wit, Ken Griffin has been quite vocal about his skepticism for the future of digital assets. And finally, as we will detail later in the report, Alphacution’s analysis even detects an implied level of skepticism about the capacity of exchange-traded fund (ETF) strategies.
Adding to the contextual framing, we now turn to the available data, starting with Citadel Securities’ position and portfolio segmentations. Now, before we get to deep into this, it’s important – as a primer – to understand why positions accumulate on the balance sheet of a firm that possesses the capacity to trade up to the highest native speeds across the broadest spectrum of products, asset classes and regions.
Rebate and payments for order flow (PFOF) schemes notwithstanding, the optimal scenario for a market maker is to capture spreads and go home flat at the end of each day. The next most optimal positioning, which results in the case of option market making books, is to be delta neutral at the end of each day. In this way, the market maker doesn’t need to be concerned one iota about the fundamentals of the underlying security. In a world where trading frequency is extremely high or option positioning results in delta neutrality, each security is simply a different thing to trade and no one cares what the underlying company attached to that ticker symbol does.
But, unless the market maker is trading in a manner that is sufficiently smaller than the available liquidity, being flat or delta neutral is not an accurate depiction of the world they are likely to be living in. In a world where positions are held for hours or overnight or days or longer, fundamentals and gap risks, among others, come into play; a phenomenon that destroys performance (as measured by Sharpe Ratio).
The challenge is related to scaling…
We now turn to the available data where the cache of 13F reports – which gives us a glimpse into key parts, but not all, of Citadel’s US trading activities – does allow us to clearly distinguish the long side of the market making book (because of the highest concentration of options positions) from what looks like a convertible bond arbitrage strategy (due to the highest concentration of bond positions) and a long-short equity strategy (due to the highest concentration of equity positions, (see Exhibit A9, below):
Sample Exhibit A9: Citadel Advisors Lineage – 13F Average Portfolio and Strategy Positions Segmentation by Product Class, Q1-2008 – Q4-2018
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