If equity markets in 2017 were defined by historically low volatility, that trend was blown up just six weeks into 2018, as the S&P 500 fell 47 points on February 5 and then immediately bounced back – a 3.58% round trip in the space of 15 minutes. The Vix index of S&P 500 implied volatility also experienced a violent move around the same time. It finished the day at 37.32, having opened on Friday at 13.64.
It was yet another example of random intraday stress events market-makers face on an increasingly regular basis. For Citadel Securities, the event helped justify an overhaul of its risk management framework, implemented at the beginning of the year to cope better with these short, extreme bouts of volatility.
“As a result of the changes we implemented, we were able to spot the risk, adjust our risk budget in real time in ETFs [exchange-traded funds] and options markets,” says Frank Krepelka, head of risk and trading operations at Citadel Securities.
By being able to alter its own risk limits in real time, the firm could increase its market-making capabilities in products requiring more liquidity. Previously, it used static risk controls, which were less flexible and required a manual process for adjusting the risk budget. Moving to an automated system enables Citadel to dial up or dial down individual businesses’ risk limits in real time – such as during flash, highly volatile events – while at the same time ensuring the firm’s overall risk limit is not breached.
This change was partly inspired by the volatility of August 2015, when China devalued its currency for a second consecutive day, sending shockwaves across financial markets. Other events also contributed, including the US Treasuries flash rally in 2014 and the Swiss National Bank de-pegging event in 2015.
“These types of events are occurring more and more, and we really wanted to be prepared for the next one to make sure that we continue to have the risk budget in place and capacity to stay in the market no matter what happens,” says Krepelka.
Citadel also overhauled its capital management framework, which works hand-in-hand with the new market risk structure. By looking at datasets to analyse the firm’s historical use of capital, Krepelka says it has been able to take better capital forecasts for the business.
“Ordinarily in volatility ETFs, we would have certain capital usage and a certain risk usage, but during the February 5 event, we were able to reach into our buffers and add more capacity to those areas in real time, because those are the areas that were experiencing volatility,” he says.
This practice of adjusting risk and capital limits in real-time is managed by the firm’s desk supervisors and risk managers, who do this according to policies set in conjunction with the firm’s independent risk and treasury functions. The business also has an electronic trading risk management committee which helps the firm share ideas between its different market-making businesses on a monthly basis and drives the strategy for managing risks that arise with automated trading.
Citadel has been busy innovating its product offering to help consolidate its market share across US retail and institutional markets. The firm’s total market share in US equities now exceeds the 20% it had 12 months ago and the 17% it clocked two years prior.
Clients put this down, in part, to enhancements to non-marketable limit order fill rates – stock orders that are not immediately executable as they are not aggressing the current bid-offer. Typically this volume would go to the exchanges, but by going to Citadel directly, the customer is receiving a 2%–5% increase in its fill rate versus the exchange.
The market-maker has also improved the productivity of its algo offering for clients in benchmark orders, growing the number of shares executed in this manner by 36%.
One of the highlights for the firm was its direct listing of Spotify stock on the New York Stock Exchange (NYSE) on April 3. Typically, an initial public offering (IPO) will involve an underwriter and bookrunners, which gives some security on the listing and helps drum up interest in the stock.
“What was different with Spotify is the direct listing essentially eliminated the entire pre-IPO underwriting and book-building process,” says Joe Mecane, head of execution services at Citadel Securities. “In that scenario, you want someone who has the trading expertise to be able to handle that unknown, handle the stock pricing, and be able to transition the stock from the private market to the public market in one transaction.”
In this scenario, Citadel was selected to run the transition of stock from the private to the public market in one transaction – a first for the NYSE.
“This was not only the first one that has been done on the NYSE, but also the largest by far of any that has ever been done on any exchange,” says Mecane.