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INSIDE susquehanna partners

By Margaret Elliott

Susquehanna has managed to grow and stay independent by carefully managing its alliances.

The financial markets have a way of gobbling up proprietary trading firms that have particular expertise in derivatives. O'Connor was gobbled up by Swiss Bank Corp., Nationsbank purchased Commodity Research and Trading, and Cooper-Neff is now a part of Banque National de Paris.

Susquehanna Partners is one of the last of the big independent trading firms. In 11 years, the firm has grown from modest beginnings into a 500-person firm that manages more than 340 options specialty books and trades in the financial markets of 20 countries. Operating out of its home base near Philadelphia, it accounts for approximately 2 percent of the annual volume at the New York Stock Exchange and about 5 percent of the volume at the Options Clearing Corp.

Susquehanna is a proprietary trading firm, not a hedge fund. It does not have funds under management from outsiders, but uses its own capital. To keep growing, it allies itself with banks and other financial institutions that require risk management and derivative product expertise they just don't have. And if Susquehanna's management has its way, more alliances will appear in the future.

Susquehanna was started in 1987 by five friends who had known each other since their days at the State University of New York at Binghamton in the 1970s. The five all shared a love of games and saw their future in trading options. "Our general strategy was to arbitrage the market. There are always short-term inefficiencies that we believe can be exploited. We have always stuck to our math roots,” says Jeff Yass, a managing director and founder.

We seek to arbitrage the volatility either from strike to strike in an index or an option, or index vs. index, or option vs. option. The key decision is what the distribution of the volatility is going to be.”
Jeff Yass
managing director and founder,
Susquehanna Partners

Susquehanna's core strategy relies on exploiting subtle relationships between financial instruments. "Today, in a typical derivative product, the volatility is most important,” says Yass. "We seek to arbitrage the volatility either from strike to strike in an index or an option, or index vs. index, or option vs. option. The key decision is what the distribution of the volatility is going to be.”

But as Susquehanna has found over the years, the markets change and an interesting arbitrage technique can easily be annihilated. "Before the crash of 1987, we just ‘arbed' volatility from one strike to another,” says Yass. "But after everyone started using the Black-Scholes model, the questions became, What is the skew? What is the distribution? The next frontier is correlations.” But after that? "Who knows,” laughs Yass.

The firm sees future growth coming from alliances with other organizations. At the moment, the Bank of New York is Susquehanna's only alliance. "We started out doing over-the-counter and listed currency derivatives for BoNY customers—they are the only end-users we deal with. The bank's customers needed solutions and liquidity for their risk management needs, and we brought that expertise to BoNY in order to fill those customer needs. It works to our mutual benefit,” says Susquehanna associate director Eric Noll. "We find it easy to work with BoNY because it has a flat management structure,” says Yass. "And because we make markets directly for BoNY customers, BoNY thinks and we think that we can make better prices for those customers.”

The BoNY relationship has expanded recently to include OTC fixed-income derivative products. But more important, it has fueled Susquehanna's appetite for partnering. "We see ourselves expanding geographically to Europe and Latin America, but also into OTC equity derivatives and structured financial products,” says Noll.

One of Susquehanna's notable earlier associations was with Chase Manhattan Bank. Susquehanna traded listed and OTC currency derivatives on the Chase trading floor using its own pricing models, front-office risk management and quant research. It also worked out a similar arrangement trading listed index options and futures in Tokyo with Yamaichi Securities. "Our relationship with Yamaichi was expiring as the firm collapsed,” explains Noll. "We are evaluating other potential relationships in Japan; it is a market we want to be in.”

Susquehanna's latest ambition is to move into the money management business, using the derivatives techniques it learned through years of arbitrage trading. While little or no fundamental stock picking would be performed, the funds would be directionally linked to either various domestic and foreign indices, baskets of stocks or fixed-income benchmarks. The goal of the derivatives techniques would be to add additional basis points to the returns by determining the cheapest way to gain the desired exposure.

The firm is considering entering the money management business through an alliance with a large fund manager or other large asset manager. Though it hasn't yet found the appropriate alliance, it is in discussions with a variety of active fund managers over a strategy that would complement a fundamental stock picking firm. Once the value investor has decided to own a certain stock, Susquehanna would figure out how best to execute the tradethrough convertibles, warrants, listed options or whatever is cheapest. "If you decide you want to be long, how do you do it? Using our execution and analytic capabilities, we would be able to add a couple-hundred basis points and reduce risk at the same time,” says Yass. "We would be taking the decision to own the underlying and buying it in a derivative way.” Of course, the strategy requires a big money management firm with a view on the stock market.

Susquehanna has also entered two new markets in the past year—emerging market debt and mortgage-backed securities. In both areas, it believes that there is ample room for growth internally and, possibly, through money management alternatives. With a growing track record in these areas and a desire to expand its trading opportunities, Susquehanna may find money management to be the ideal vehicle to expand from a recent entrant in those markets to a significant force.

For a firm that views the world through the window of options technology, Susquehanna has managed to find many different businesses to pursue. Yass thinks time is on the side of derivatives. "It's still a young business, and our staff is young, energetic and happy to be part of a meritocracy,” he says.