Business

Published: Friday August 3, 2012 MYT 8:02:00 AM
Updated: Friday August 3, 2012 MYT 11:14:53 AM

Knight fights for survival after computer glitch wipes off US$440mil(Update)


NEW YORK: Knight Capital Group Inc fought for survival on Thursday after a US$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 partners 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 and subsequent damage to business.

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 act sooner.

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.

Late Thursday, the firm planned to set up a data room 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.

A Bloomberg report said 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 $440 million trading loss has reignited debate over whether technology has elevated risk in trading to unacceptable levels.

The U.S. Securities and Exchange Commission on Thursday said it would consider whether new measures might be necessary to safeguard markets.

"We continue to closely review the events surrounding yesterday's trading and discuss those events with other regulators as well as Knight Capital Group," 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," Nester said.

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."

USING OTHER MARKET MAKERS

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.

He said as long as Knight remains in good standing with the exchanges, TD Ameritrade will resume sending orders through it.

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.

Longview Capital Management, LLC, a Wilmington, Delaware-based registered investment adviser with $200 million in assets under management, is holding off from trading with Knight until "it gets its act together and tell us where they stand," said Christian Wagner, chief executive and chief investment officer of the firm.

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.

An official from AdvisorShares, an ETF provider with $670 million in assets, said officials from Knight called him Thursday morning and addressed his concerns about some of AdvisorShares' ETFs that were trading at wider spreads than they would normally. That can happen when market makers are not fulfilling trades.

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

ATTENTION FROM REGULATORS

The Financial Industry Regulatory Authority, the industry's self-regulator, said it has examiners at Knight and was working with the firm and other regulators to review the impact from the technology issues. It said Knight was currently in compliance with capital requirements.

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 Penson 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.

It took 45 minutes to resolve the problems, again pointing to the inability of individuals to contend with out-of-control 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 another all-time low, falling to $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.

Knight Capital Group's Chief Executive Tom Joyce is considering bankruptcy reorganization and a sale of assets, according to reports by Fox Business Network.

A trading glitch with Knight's software roiled markets and wiped out $440 million of the firm's capital, forcing it to seek new funding as its shares plunged more than 80 percent in two days.

A number of brokerages and broker-dealers have suspended routing trading orders through Knight. Among them: TD Ameritrade, Scott Trade, Fidelity Investments, Vanguard Group, E*Trade and Pershing LLC, a division of BNY Mellon. - Reuters

Analysis: Knight trading loss shows cracks in equity markets

The software glitch that cost Knight Capital Group $440 million in just 45 minutes reveals the deep fault lines in stock markets that are increasingly dominated by sophisticated high-speed trading systems. But Wall Street firms and regulators have few easy solutions for such problems.

Automated trading can handle massive volumes of transactions in milliseconds, something human traders could never do. But the benefits come at a cost: stock markets have become a jumble of exchanges, market makers, high-frequency traders, and investors using different systems that can interact in unexpected ways.

The May 2010 'Flash Crash', in which U.S. stocks inexplicably sank in a matter of minutes, illustrated how technological problems can cascade. These sorts of problems may be more likely given that many market participants are under pressure to cut costs - including technology spending - as trading margins narrow and regulation costs increase.

Since April, a series of embarrassing and costly technology issues have rocked markets and shaken the confidence of investors.

BATS Global Markets, an exchange, was unable to complete its own initial public offering because of a technical problem. Nasdaq botched the market debut of Facebook due to technical glitches, costing it tens of millions of dollars, while UBS AG lost more than $350 million in trading Facebook shares and is blaming Nasdaq.

"The structure just may be too complicated to work," said Larry Tabb, founder of Tabb Group, a consulting firm that focuses on capital markets.

"We may need to think about changing the structure of the market to simplify this," Tabb added.

'DARK POOLS'

Others argue that regulators can continue to take relatively simple steps, such as creating more finely tuned mechanisms to halt stock trading when trading volumes or prices move too much.

Bernard Donefer, who teaches at the NYU Stern Graduate Business School and CUNY's Baruch College, said that new, broader limits on stock swings that are slated to be tested by regulators in February would have helped.

If the latest cars can sense approaching objects and stop automatically, "we need those kinds of controls" in the markets as well, he added.

In the old days, it was simpler: human traders known as "specialists" worked on the floors of stock exchanges, such as the New York Stock Exchange, to match buyers with sellers and complete trades themselves if matches couldn't be made.

But over the past decade, those specialists have been replaced by automated trading systems, and much trading volume has moved away from exchanges and into other venues, such as "dark pools" - trading systems that let investors anonymously buy or sell larger blocks of stock without tipping their hand to a wider market.

Knight Capital, which makes most of its money by executing trades for other brokerage firms, said that a new trading system it installed sent a flood of bogus trades to the market. The loss means that the firm is now fighting for its survival.

BETTER TESTING

Outsiders questioned why Knight did not pre-test the new software more assiduously, and why the bad trades continued to be generated for more than half an hour, instead of being shut down by internal systems almost immediately.

New York quantitative hedge fund owner Roy Niederhoffer said that there was "no excuse" for Knight failing to act sooner.

"This is like a nuclear reactor or aircraft," said Niederhoffer, whose R.G. Niederhoffer Capital Management uses Knight. "There has to be some way of seeing the state of the whole system."

Trading system glitches often arise with the installation of new systems or computer code. But experts said that market participants constantly need new systems to accommodate new rules and changing customer demands - particularly from high-frequency traders.

For example, many trading systems were modified this week to conform with a new retail order-taking system introduced at the New York Stock Exchange and to accommodate a French securities transaction tax that took effect on Wednesday.

The U.S. Securities and Exchange Commission has been grappling for years with ways to create a national market system that uses technology to ensure that orders to buy and sell shares are sent to the best possible exchange, dark pool, or other venue. After the shock of the 2010 Flash Crash, it also began exploring fail-safe mechanisms to prevent technology-induced disasters.

Some of those measures, including halting trading in a stock that rises or falls beyond predetermined limits, kicked in on Wednesday, protecting investors but not saving Knight from losing big.

To be sure, many experts pooh-poohed the wider significance of Knight's problem.

"Coding problems happen, but it's not an industry issue," said Matt Andresen, founder of proprietary quantitative trading firm Headlands Technology and a former trading head at a Knight competitor. "I don't know what happened at Knight, but they had a self-inflicted problem that only hurt them. That's the way the market is supposed to work."

Maureen O'Hara, a finance professor at Cornell University who sat on a special advisory panel that explored Flash Crash reforms, agreed. "I'm very worried people will take a look and say there is something fundamentally wrong with the market, and there isn't," she said.

Some traders and critics said that more details need to come out before they could draw too many conclusions other than the importance of software testing.

One thing that's clear: the financial system is much more elaborate now than it was a decade ago, and finding solutions to market problems is not easy.

"We have a very complex financial system, bordering on the baroque," said NYU's Donefer. - Reuters

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