These guys get it.
It’s not like they exactly need my validation. But if you want to glimpse into the future of what would generically be called “investment banking” a good place to start would be at Citadel:
Since its founding in 1990, Citadel has grown into one of the world’s most sophisticated alternative investment institutions. Our team of professionals allocates investment capital across a highly diversified set of proprietary investment strategies in nearly every major asset class. Through a combination of world-class talent and the use of advanced technology to suppoer them, we relentlessly seek to initiate and capitalize on change in the global financial markets with the goal of remaining at the forefront of the industry.
I must confess to a very limited knowledge of the firm, based almost entirely on what I have read in the press and taking note of the deals they have done and how they have approached the business of investing. (So please accept that my opinions on Citadel are based on conjecture and are accordingly quite possibly off the mark.) What has always resonated with me is their emphasis on building a robust, scalable infrastructure based on viewing technology strategically as a core component of their approach to investing and financial markets more generally. (For those unfamiliar with Citadel, here is a Bloomberg Magazine article that gives a good overview.) Citadel Solutions formed earlier this year to leverage their leading edge infrastructure is a case in point:
The Citadel Solutions team is at the forefront of shaping processes within the capital markets, taking leadership positions in industry working groups and continuously driving improved workflow. This passion for process is a cornerstone of our culture and represents the close partnership between our people, our technology and our clients. As a result, our technology is continuously updated to support best practices and we believe in perpetually strengthening our team with the best talent available to deliver the highest levels of service.
This combination of People, Process and Technology has been central to our success and is now available through our administrative service offering. By partnering with us, our clients can focus on their core business of investing, while leveraging the unique and advantaged position of Citadel Solutions to support their middle and back office service requirements across nearly every asset class, market and geography.
With this in mind, let’s say I wasn’t surprised when I heard that Citadel was injecting a large amount of capital into E*Trade. I won’t pretend to know whether or not (or even how) the numbers stack up - I don’t have the resources at my disposal to undertake that kind of analysis but I suspect it will be a great deal for Citadel and one of those deals where frankly I wish I had the financial and human resources to have done.
Most of the commentary on the deal has been focused on the purchase of E*Trade’s distressed sub-prime assets at what would seem to be an attractive price. Indeed this would seem to be a major part of the financial risk Citadel is taking and is interesting in the context of establishing clearing prices on these types of securities and (hopefully) encourage the return of liquidity to these markets around a new pricing equilibrium. I have no idea as to whether or not Citadel will make money on this (I suspect they will) but I see this as the less interesting part of the trade, at least from a strategic point of view. Assuming that you ring-fence that part of the trade - which after all is ‘just’ buying a portfolio of assets and so is ‘just’ a question of price (as to whether it was a good or bad trade) - it would seem to me that you are left with Citadel taking a large (and cheap) position in E*Trade’s core operating business: a (relatively) modern, electronic agency retail securities trading and distribution business. This type of business is potentially very valuable (one only has to look at the valuations of their erstwhile peers - TD Ameritrade, Schwab - or the recent purchase by Goldman Sachs of 10% of CMC Markets in the UK valuing it at c. $2.5 to $3bn), and notwithstanding the fact that the E*Trade franchise is somewhat tarnished by their recent troubles, could prove to be a very cheap option if they can now isolate their core operating business from the mess because of the Citadel deal.
Furthermore - and this is pure speculation on my part - I imagine there are additional benefits to Citadel from having such a strong position in this kind of distribution and trading platform: it is a great place for Citadel to originate and distribute risk. Indeed it is my understanding that E*Trade historically was a big customer of Citadel’s options market-making business; the potential to grow this kind of relationship would be beneficial to both firms.
I must admit to being slightly confused as to why E*Trade ever thought it was a good idea to get into the business of taking principle risk. I mean they were outside the historical (and sub-optimal) banking/securities firm paradigm, and yet like a moth to a flame used their success to migrate their business model into the conformist Wall Street main stream. Marrying agency intermediation, distribution and origination businesses with principal risk taking in the same capital structure just doesn’t make sense: the incentives are all wrong and the risk/return/capital equations for each type of business are entirely different. With toxic results - it’s not just theory. Principal risk taking is intensive in financial and infrastructural capital needs, and light in human capital. The agency businesses are intensive in human and (in some cases) infrastructural capital needs, and light in financial capital. However the human and organizational dynamics of corporations do not allow these distinctions to be applied, or at best only at the margins. So what? Well let’s just say the best job in a modern universal bank is running the loan portfolio; in good times you have no losses and so good returns and usually the agency side of the business does well too. This is important because your compensation is anchored in the firm. If your star salesperson is paid $5 million for generating $50 million of revenues, well ‘your’ revenues of $200mn should get you paid at least as much right? Only the salesperson used a few hundred thousand or maybe millions of capital (needed from a regulatory point of view) while you used a few tens (or even hundreds) of millions. The capital made the money. Not you. Of course that’s obvious, no way that the compensation policy doesn’t take this into account you say. Trust me, it’s not completely ignored of course, but the arb works. And then in bad times everyone is screwed but since it’s not a partnership, the portfolio guy isn’t giving anything back even if he’s down $400mn. The worst the agency guy can do is a goose-egg, so at least compensation is (broadly, ignoring fixed operating costs) symmetrical.
But even ignoring the distortions engendered by the internal compensation arbitrage, as an investor you are buying a bucket of gray paint which is unnecessarily hard to price - you’d be much better off buying the individual colors and mixing them yourself. The portfolio effect within the firm is good for management - they reap the benefits of diversification, while for investors they only see a dulling of returns and a dilution of accountability. The optimal capital structure for an agency business is very different than that of a principal investment business.
I’m not sure this is all very eloquently articulated. It’s probably an essay not a blog post…but perhaps it will help clarify slightly if I tell you where I think this inevitably will lead us to (but it could take 20 years): a world where you have regulated pools of capital (banks), unregulated pools of capitals (hedge funds), originators/distributors (customer-facing) and exchanges. Each with an optimized capital structure aligned to the nature of their underlying financial and/or operational risk. Now it’s not to say there won’t be any loose coupling of all of these, but for example - and coming full circle I hope - Citadel owning 20% of (a pure agency) E*Trade might be the kind of thing we see more of not less in 2020.
