Risk Awards 2016
It won't quote on non-cleared interest rate swaps. It won't quote on cross-currency swaps or swaptions. In fact, it doesn't trade any swap currencies apart from US dollars and euros. It won't hold a corporate treasurer's hand as the client struggles through a painful debt-and-hedge restructuring. It doesn't offer research, or have armies of salespeople and traders dotted around the world.
But in the chunk of the market where Citadel Securities is active – primarily plain-vanilla, US dollar interest rate swaps traded on swap execution facilities (Sefs) via request-for-quote (RFQ) – the firm has achieved something unique over the past 12 months. It is the first outsider to break into this bread-and-butter swaps business, and – more importantly – it has changed the way others play the game.
"Citadel has improved the market structure, in terms of people quoting sharp prices and coming back faster. It's really forced the dealers to move – I really like that aspect. Even when they don't win, they've done a good service to the industry, making sure others compete on the same terms," says a senior trader at one large US asset manager.
While Citadel already had a strong track record in US equities and more recently US Treasuries, as well as futures and options, its swap trading operation only opened for business on Sefs run by Bloomberg and Tradeweb on October 27, 2014. From a standing start, by the end of 2015 the firm was ranked first on Bloomberg's Sef by volume, response time, hit ratio, client enquiries and risk traded.
It claims an average RFQ response time of 0.36 seconds compared with an industry average of around four seconds, and quotes at roughly 0.2 basis points across the curve, depending on market conditions. It also does this in size, streaming prices for trades up to $120,000 of DV01 – the per-basis point interest rate sensitivity – via Bloomberg's click-to-trade protocol, and auto-quoting trades up to $700,000 DV01.
This combination of size, speed and thin spreads has helped make it the darling of many of the largest derivatives users in the US market – not just hedge funds, which might be expected to care most about Citadel's strengths, but also pension funds, corporates and even government agencies.
Citadel has improved the market structure, in terms of people quoting sharp prices and coming back faster. It's really forced the dealers to move
Senior trader, large US asset manager
"At this point in time, November, I would say they're in our top five counterparties – from nowhere. We trade billions of dollars of swaps, and to make it into our top five is a remarkable feat. It's really commendable," says the senior trader at a large US asset manager.
A source at a hedging advisory firm that trades on behalf of corporates, banks and private equity firms says Citadel has been open to trading with any type of market participant.
"Citadel really has impacted the market. It was the first to say ‘We'll respond to anyone's RFQ, and we won't discriminate by who's on the other side of the trade'," he says.
Getting to that point was hard work – most buy-side players have long and deep relationships with the large dealers, spanning everything from futures to securities financing trades. Paul Hamill, global head of fixed income, currencies and commodities at Citadel Securities in Chicago, says the firm's pitch to clients was centred on how it would differ from the dealers. Size, speed and tightness of price are helpful differentiators, but one of the jewels in the crown was its commitment to firm pricing – that is, it honours the quote it gives the client, which is not always the case with other dealers.
"Half the Street will not honour what they're showing. Citadel is always there. It gives us huge comfort to trade. Even if it's not the best offer, we like trading with them anyway," says a derivatives trader at one large US hedge fund.
Its timing was also right. With dealers increasingly pulling liquidity from everyone but the most favoured clients, many buy-side firms have been looking for alternatives.
"The quandary many clients face as traditional liquidity providers pull back is in identifying new and sustainable sources of liquidity. A number of clients I have met said they're at the point where they're revisiting their approach to liquidity – who they source it from, the factors they consider when selecting providers, the service model overall and in particular the ability to deliver consistency," says Hamill.
One corporate pension fund says it was dropped as a client by bulge-bracket banks, so brought on Citadel as an alternative liquidity provider. It's not just smaller clients, though – one very large US hedge fund praises Citadel for being there when the banks increasingly are not.
"I don't know how you could give the award to anyone else. Every bank out there has reduced the risk capital it allocates to interest rate derivatives by huge amounts. Everyone's down, and all the senior people have left. There's no-one over 30 willing to pick up the phone anymore," says the chief risk officer of one large US hedge fund.
Half the Street will not honour what they're showing. Citadel is always there. It gives us huge comfort to trade. Even if it's not the best offer, we like trading with them anyway
Derivatives trader at one large US hedge fund
This is another key part of Citadel's pitch. The firm claims it will price through thick and thin, and will not pull the shutters down when volatility rises – the standard knock against non-bank market-makers. Does that claim stand up? Hamill points to its record last year – the firm ranked second by risk traded on Bloomberg's Sef through China's so-called Black Monday on August 24, and through the bout of unexpected volatility on June 3, when comments from European Central Bank chief Mario Draghi sent markets into a panic.
So, how can Citadel quote razor-thin spreads across the curve and stand behind those quotes when other dealers – apparently – cannot? Some point to the fact that the firm does not face the same capital rules as its competitors. This is true, but while it doesn't face some of the bank-specific requirements such as the leverage ratio, it still faces stringent oversight under the UK and US broker-dealer regimes.
Citadel's own explanation has two pillars. First, the firm had the benefit of building its technology from scratch, instead of having to deal with layers of legacy systems that the dealer banks have built up through numerous acquisitions over time. This allowed Citadel to minimise the manual tasks that can slow down the trade process, which can reduce a firm's ability to get straight back into the market to get more involved in flow.
Second, Citadel autohedges most of its interest rate swap flow with a variety of different instruments – something dealers aspire towards but have not yet turned into standard practice.
"When we are hedging duration on these trades using instruments like US Treasuries or futures contracts, we've automated most of that for the majority of trade sizes. In fact, whenever we have a price on the screen the model is continuously evaluating the optimal hedges," says Hamill.
Citadel's head of interest rate swap trading, Yanfeng Chen – who joined from Credit Suisse in June 2014 and was responsible for building the model – says the firm's auto-pricing machine behaves as if every quote it sends out is executed.
"Because we treat every quote we send out as if it will be executed, we are continuously evaluating it to make sure we correctly price the instruments and how we're going to hedge when a trade is executed," says Chen.
"Thinking in reverse allows us to have a high degree of automation if any of these trades are done. We don't try to figure out how to hedge and whether our price is correct after a trade is accepted, which allows us to be quicker and much more consistent across the board," he adds.
Because we treat every quote we send out as if it will be executed, we are continuously evaluating it to make sure we correctly price the instruments and how we're going to hedge when a trade is executed
Yanfeng Chen, Citadel Securities
Chen says they also constantly track and validate many of their modelling assumptions, to keep up to date – second by second – with what's happening in the market. This vigilance allowed the firm to adjust its hedging strategy when the cash Treasury yield dipped below the US dollar swap rate in September.
"Hedging shouldn't be static. Always using the exact same amount of instrument B to hedge instrument A is probably not the right way to do it. The composition and weighting of the hedging instruments will change throughout the year, sometimes throughout the day as well," says Chen.
While Citadel has carved out a strong market position in plain-vanilla US interest rate swaps, it's also offering switches, butterflies, market-agreed coupon swaps and swaps beginning on international monetary market dates.
It is also making a push into euro interest rate swap trading, having started quoting on interdealer platforms at the tail end of 2015. Hamill expects it to take a bit longer to get the same level of market penetration as in the US, as mandatory electronic execution and clearing rules are yet to come into force in Europe.
More surprising for an electronic trading firm, Citadel is also moving into voice trading. The firm hired a trader in Europe last year, with two more due to join in the US in the first quarter of 2016. Hamill says the decision to move into voice isn't the result of customer demands, but just because it took time to work out how to differentiate themselves from rivals that already trade by phone.
"The scenario where clients make a call is when they are looking for liquidity in size, seeking to protect their own execution from information leakage and validating appetite to trade," says Hamill.
"With our consistency, appetite for size, and our large share of flow, we have demonstrated they will always get a competitive price, and that is a compelling reason for us to get the call. The team we have is highly specialised in voice execution, equipped with great tools and laser focused on fast and seamless price discovery and execution," he adds.