Knight Capital’s Future in Balance after $440 Million Trading Disaster

By Edward Krudy, Jed Horowitz & John McCrank | August 3, 2012

Knight Capital Group Inc fought for survival on Thursday after a $440 million trading loss caused by a software glitch wiped out much of its capital, forcing Knight to seek new funding as its shares plunged as much as 80 percent in two days.

Many of the company’s biggest customers, including TD Ameritrade, the No. 1 U.S. retail brokerage by trading volume, and fund giants Vanguard and Fidelity Investments, stopped routing orders through Knight. One of the biggest fears is that the company will collapse, landing trading clients and creditors with losses.

“They have about 48 hours to shore up confidence,” said James Koutoulas, head of an advocacy group for former customers of failed brokerages MF Global and Peregrine Financial.

Knight said it is “actively pursuing its strategic and financing alternatives,” raising the likelihood the firm will be sold or face bankruptcy because of the loss, which is about four times its annual net earnings, and the subsequent damage to its business as customers and others question its stability.

As one of the leading market makers in U.S. stocks, Knight is among the firms that are critical to smooth, orderly trading. Market makers match orders from buyers and sellers and often provide liquidity by stepping into the market themselves.

The speed at which Knight has unraveled has been particularly unnerving for investors and markets. It resulted from problems with the firm’s trading software that sent bogus, rapid-fire trades into the market for 45 minutes on Wednesday and left Knight with big losses on numerous stocks it bought at inflated prices.

“This is like a nuclear reactor or aircraft,” said Roy Niederhoffer, whose R.G. Niederhoffer Capital Management uses Knight. “There has to be some way of seeing the state of the whole system.” He said that there was “no excuse” for Knight failing to stop its systems before the glitch had endangered the firm.

OPENING UP THE BOOKS
Knight is in talks with Silver Lake Partners-backed trading firm Virtu Financial LLC about a possible deal, according to The Wall Street Journal. Knight has approached JPMorgan Chase & Co for financing, according to a report on Fox Business Network. A spokesman for JPMorgan declined to comment. Spokeswomen for both Knight and Silver Lake also declined comment.

The firm planned to set up a data room late on Thursday for potential bidders to comb through its books, according to a source familiar with the situation. Some private equity firms were weighing whether to look at the company, the source added, saying that the situation was fluid.

Bloomberg reported the firm had hired Sandler O’Neill and Goldman Sachs to advise it on next steps. Goldman and Sandler O’Neill officials declined to comment.

“You have to find someone who is willing to move pretty quickly,” the source said. “It is a confidence issue.”

Knight’s trading loss has reignited debate over whether technology has elevated risk in trading to unacceptable levels.

The U.S. Securities and Exchange Commission said it would consider whether new measures might be necessary to safeguard markets – in addition to those introduced after the 2010 Flash Crash in which stock prices went into an almost inexplicable dive in the space of a few minutes. “We continue to closely review the events surrounding yesterday’s trading and discuss those events with other regulators as well as Knight Capital,” said SEC spokesman John Nester. “We also are considering what, if any, additional steps may be necessary, beyond the post-Flash Crash measures that limited the impact of yesterday’s trading.”

Examiners from the SEC were onsite at Knight’s offices on Thursday, according to a person familiar with the matter.

The SEC is looking at whether or not Knight was in compliance with a “market access” rule, the source said. That rule requires broker-dealers to create financial risk management controls to prevent orders that are erroneous or exceed pre-set capital or credit thresholds.

The SEC will be examining whether more rules need to be in place to prevent problems like this from occurring in the first place, and whether the market access rule should be tweaked, according to the source.

Another person familiar with the matter on Thursday said it is too early to know whether the SEC’s enforcement division will step in to investigate Knight.

The Financial Industry Regulatory Authority, the industry’s self-regulator, has also sent examiners to Knight. It has said that Knight is still in compliance with capital requirements.

Advocates of trading systems that can pump thousands of shares across Wall Street in milliseconds say the fault lies not in the systems but in the lack of controls at individual firms. Knight blamed its technology breakdown on new software that routed a flood of erroneous orders to the New York Stock Exchange on Wednesday, but offered no explanation as to why traders didn’t immediately intervene to arrest the obvious errors.

DISASTERS SEEN INEVITABLE                                                                                                   Trading veterans say the sprawl of trading venues in the United States coupled with the constant tinkering with software codes and systems upgrades have led to such complexity that disasters are bound to occur.

Since March, a series of embarrassing technology issues, including the botched Facebook trading debut after its IPO and the failed public offering of BATS Global Markets have rocked markets and shaken the confidence of investors.

“You’ve got 13 exchanges, 50 dark pools, brokers that internalize client orders at their own desks and thousands of algorithms pumping orders in milliseconds,” said Larry Tabb, founder of  Tabb Group, a financial consulting firm. “The structure just may be too complicated to work.”

But some experts fear that a regulatory and populist backlash – let alone protests from competitors – will reverse advances that benefit investors.

“I’m very worried people will take a look and say there is something fundamentally wrong with the market, and there isn’t,” said Maureen O’Hara, a finance professor at Cornell University who sat on an advisory panel that explored reforms after the U.S. stock market collapsed inexplicably in a few minutes in the 2010 “Flash Crash.”

CUSTOMERS DESERTING
Several large retail brokerages said they had not resumed trading with Knight, instead routing orders to other market makers. TD Ameritrade, which usually routes about 4.5 percent of its orders through Knight, is currently not sending orders through the firm, said Joe Kinahan, its chief derivatives strategist.

Mutual fund group Vanguard Group, which typically routes about a quarter of its NYSE and NASDAQ trades through Knight, was sending orders elsewhere. Scottrade, E*Trade, TD Ameritrade, Pershing LLC, a subsidiary of BNY Mellon , Invesco and Fidelity were all shifting orders elsewhere.

In 2011 Knight was the No. 1 market marker in retail U.S. equity shares traded in NYSE and NASDAQ stocks. Knight’s daily market-making volume was $19.5 billion in June, down 12 percent from a year ago as overall equity trading volumes have declined.

There were questions about how the firm’s possible failure could affect the network of 800 smaller brokerages that rely on it to process orders, said Chris Nagy, a market structure consultant. “Although they have very small amounts of order flow, in aggregate, (they) represent a significant amount of volume,” he said.

Exchange-traded fund issuers, for which Knight is the lead market maker, have been calling competitors to make sure they can step in if Knight does not execute trades in their funds, according to two people familiar with the situation.

Retail investors and traders who want to buy and sell small, illiquid exchange-traded funds may be unwittingly losing money because of wider spreads in the bid and ask price of the ETFs available through Knight since the incident, according to an analysis by IndexUniverse, a San Francisco-based ETF research provider.

While securities regulators are looking into what went wrong on the trading side, the focus in the futures industry is on the estimated $411 million in customer funds that were part of Knight’s purchase in May of floundering futures brokerage Pension Financial Services.

Confidence in the futures industry’s ability to safeguard customer funds has been shaken after the collapse of futures brokerages MF Global and PFGBest in the past year was followed by accusations that they improperly raided customer accounts.

WORKING IN THE DARK
 From even before the opening bell on Wednesday, traders across the market noticed something wrong, saying they saw heavy “indicated” volume for stocks that normally trade infrequently.

As soon as the market opened, an unusually high flow of orders in more than 140 stocks came in, causing shares to move rapidly. Knight later attributed the moves to software problems that caused little-traded shares like China Cord Blood to rise sharply, with some gaining more than 100 percent within seconds.

According to floor traders, Knight staff working on the NYSE’s floor were in the dark as well. According to sources, algorithmic trading of this type is separate from regular trading at the company’s Jersey City, New Jersey, headquarters.

“The guys are down here on the floor so they were just as caught off guard because they were actually suffering some of the consequences of the failure of their own technology,” said Ken Polcari, managing director at ICAP Equities in New York, who trades on the floor of the exchange.

As the crisis unfolded, traders at Knight were fielding numerous calls and talking with officials in the firm’s technology department, who confirmed that the problems were originating with Knight’s software, and not with the NYSE.

The length of time it took to halt the mistaken trading spotlighted the inability of individuals to sometimes keep in control of computer-based trading.

Knight’s shares closed down 63 percent at $2.58 a share in NYSE trading on Thursday. In after-market trading the stock hit an all-time low, falling to around $2.10, but moving back to $2.38 by early evening.

The firm’s survival may rest in the hands of Knight Capital CEO Tom Joyce, who told Bloomberg Television on Thursday the firm had “excess capital right now,” and said the goal was to keep Knight in business.

When Joyce arrived in mid-2002 after the dot-com bust had devastated the U.S. stock market, the market-maker was struggling because of low trading volumes and high payouts made to attract business from discount brokers.

Joyce, whose laid-back demeanor distinguishes him from many more volatile executives in the trading business, spent 15 years at Merrill Lynch & Co., and has considerable contacts on Wall Street if a rescue deal is possible.

“Whenever you have a company that lost roughly half of its tangible book value in five minutes, everything is on the table,” said Kenneth Pasternak, who co-founded Knight in 1995 and served as its chief executive until he retired in 2002. “All he has to do it is pick up the phone.”

Joyce has seen his considerable stake in his firm almost wiped out in a matter of hours. As of April 2, Joyce owned more than 1.2 million shares of Knight Capital, with a market value of nearly $16 million — a stake now worth less than $3 million.

“Unless Tommy Joyce can do some really massive damage control and calm the markets and let everyone rest assured they are OK and they are not going out of business they’ve got some rocky days in front of them,” Polcari at ICAP said.

 

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