Citadel Derivatives Group is making a minority investment in Direct Edge ECN, signaling a change in strategy for parent Knight Capital Group, which is now looking to attract a consortium of direct investors to grow the ECN's volume to the next level.

According to today's announcement, Citadel Derivatives, an affiliate of Citadel Investment Group, LLC, the alternative asset manager, which is a leading equity market maker in its own right, has agreed to purchase a minority stake in Direct Edge ECN.

“We believe that the consortium approach and finding strategic investors will be the best way for Direct Edge to grow the fastest,” says John Howard, CFO at Knight Capital in an interview.

Though Knight Capital has “enjoyed considerable success with Direct Edge as a wholly owned subsidiary, “We do think being an independent company supported by direct investors is our best strategy for growth,” says Howard. Launched in October 2005, Direct Edge currently averages more than 200 million shares a day and had a high of 299 million shares on June 26, 2007.

Though Knight will still own the majority stake, the firm is looking to add other strategic investors "who own significant order flow and who share our vision for market share and our belief in the low cost utility business model that we run,” adds Howard.

The strategy sounds similar to that of rival BATS Trading, operator of BATS ECN, which also took in several strategic investors and recently announced plans to become an exchange. (BATS passed 300 million shares on January 26, 2007. In May, BATS added Citi as a minority investor joining Credit Suisse, Lehman Brothers, Lime Brokerage, Merrill Lynch and Morgan Stanley.)

“That strategy of expanding their consortium and having a plan to partner to become an exchange is no different than what Edge would do,” conveys Howard.

Knight’s CFO notes there are a variety of ways to attain exchange status, including partnering with an exchange, noting there are several regional exchanges. “That’s something that Citadel and Knight and future investors will work through as the consortium evolves,” he says.

In general the benefits of turning an ECN into an exchange would to retain a higher share of the market data revenues derived from executions on the exchange. Second, an exchange can significantly reduce its clearing costs by contrast to a broker-dealer, he says.

But the exchange side of the equation is a mid to long-term goal, emphasizes, Howard. The primary goal in the short term is to bring together a series of strategic investors and to expand its management team. Knight is looking for strategic investor with significant order flow that can support the ECN as an execution destination.

Knight partnered with Citadel because of its competitive position as a fellow equity market maker. “They’re a formidable peer in the market,” says Howard. In 2005, Citadel made an investment in the Philadelphia Stock Exchange, to help expand its market share in equity options, which was tied in with Philly’s new electronic options trading platform, PHLX XL. But Citadel’s’role as an options-market maker didn’t play into the Direct Edge investment, says Howard.

As part of the change, Knight Capital hired Nasdaq SVP William (Bill) O’Brien, 36, to become CEO of Direct Edge ECN, LLC, as of July 30, 2007. O’Brien will oversee daily operations as well as lead the expansion efforts of the ECN. O’Brien is an SVP at the Nasdaq Stock Market which he joined in 2004 following the acquisition of BRUT ECN. William Karch, 54, who has been CEO of Direct Edge ECN since March 2006, will remain under O’Brien when the transaction is completed.

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