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Some ETF Spreads Widen as Knight Capital Seeks to Survive

The average spread between bid and offer prices for some lightly traded U.S. exchange-traded funds widened yesterday as Knight Capital Group Inc., the biggest market maker for ETFs, struggled to survive.

Spreads on low-liquidity ETFs for which Knight is the lead market maker on the New York Stock Exchange rose to 1.53 percent yesterday, according to data compiled by research firm IndexUniverse LLC. The spread averaged 0.49 percent before Aug. 1, when a computer glitch at Knight caused losses nearly four times the firm’s profit last year.

Knight Capital handled the largest share of ETF trades in the first quarter of 2012 with 17 percent, according to the firm’s website. The firm, based in Jersey City, New Jersey, is in contact with creditors, clients and counterparties after a “fairly major” software bug caused trading errors costing it $440 million, Chief Executive Officer Thomas Joyce said yesterday on Bloomberg Television’s “Market Makers” with Erik Schatzker and Stephanie Ruhle.

“ETFs are dependent on third parties” to make markets, Paul Justice, head of ETF research in North America at Morningstar Inc. (MORN), said in a telephone interview. Should the firm fail, “There would probably be a temporary gap in liquidity until someone else steps in with that volume.”

Photographer: Jonathan Alcorn/Bloomberg

Thomas Joyce, chairman and chief executive officer of Knight Capital Group Inc. Close

Thomas Joyce, chairman and chief executive officer of Knight Capital Group Inc.

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Photographer: Jonathan Alcorn/Bloomberg

Thomas Joyce, chairman and chief executive officer of Knight Capital Group Inc.

Kara Fitzsimmons, a spokeswoman at Knight Capital, didn’t return phone calls and e-mails seeking comment.

Secured Financing

Knight Capital told brokers it secured short-term financing to fund market making today, said a person with knowledge of the matter who requested anonymity because the conversations were private. Its shares rose as much as 37 percent today after falling 75 percent over the previous two days.

Knight Capital yesterday opened its books to potential buyers, including private-equity firms and at least one securities- industry rival, said two other people with knowledge of the matter.

Knight Capital is working with Goldman Sachs Group Inc. and Sandler O’Neill & Partners LP as advisers in the rescue talks, said one of the people, who spoke on condition of anonymity because the discussions are private. The company is under pressure to strike a deal within days, the people said.

Invesco Moves

Invesco Ltd. has added additional market makers in the past two days to all of the more than 40 ETFs supported by Knight Capital, Ben Fulton, managing director of global ETFs, said in an interview. Invesco manages $55 billion in about 126 ETFs in the U.S., according to data compiled by Bloomberg.

“On day one we noticed a little wider spreads, but in the last 48 hours a lot of market makers have signed up, so the spreads are back to normal now,” Fulton said.

Investment firms including Vanguard Group Inc. and WisdomTree Investments Inc. said Knight Capital’s struggles haven’t significantly affected its role as a market maker for ETFs.

“Spreads are roughly the same today as before this issue, maybe slightly wider in ETFs for which Knight is the lead market maker,” said David Abner, head of capital markets for WisdomTree Investments, the New York-based ETF provider founded by hedge-fund manager Michael Steinhardt.

Knight Capital is lead market maker on 7 of the firm’s 48 ETFs, he said.

“We are monitoring the situation and have contingency plans in place if needed,” said David Hoffman, a spokesman for Vanguard, the third-largest U.S. ETF provider. “In the meantime, our products are trading normally.”

Robust Competition

Market makers are firms that help ensure liquid markets by being willing to buy and sell securities. All U.S. ETFs have at least two market makers and the competition for such agreements is robust, according to David Nadig, director of research at San Francisco-based ETF IndexUniverse.

“Even in the worst-case scenario, there’s an awful lot of quality competition that will be more than willing to jump in and pick up the slack,” Nadig said.

Ryan Issakainen, ETF strategist at Wheaton, Illinois-based First Trust Portfolios LP, said the firm hadn’t detected any reduced liquidity today in its products that use Knight as a market maker. The company manages 70 ETFs with about $7.3 billion in assets, according to data compiled by Bloomberg.

Rerouting Trades

Separate from ETF market-making, Vanguard’s brokerage unit had stopped routing client trades through Knight Capital, spokesman John Woerth said in an e-mail. The brokerage unit of Boston-based Fidelity Investments, the world’s second-biggest mutual fund provider behind Vanguard, was also directing trades away from Knight, according to a person familiar with the matter, who asked not to be identified because the information is private.

After rerouting its trades yesterday, TD Ameritrade Holding Corp. resumed dealing with Knight today, Chief Executive Officer Fred Tomczyk said.

Market makers also play a key role in keeping ETFs priced in line with the value of their underlying assets. When those values diverge, market makers create or redeem shares in large blocks, moving fund share prices back in line with assets.

“Providers are concerned because it’s our job, but I don’t think investors should be worried,” Scott Ebner, head of ETF product development at Boston-based State Street Corp. (STT), the second-biggest biggest provider of ETFs worldwide. “The competitive process is what drives efficiency in the market, not a single participant.”

Knight Capital is the lead market maker for 54 State Street U.S.-registered ETFs, or about half the U.S. total. Replacing a lead market maker wouldn’t be difficult, Ebner said

Reginald Browne, who joined Knight Capital along with a team of managers and traders from Newedge USA LLC in 2009, leads the firm’s ETF trading group.

To contact the reporter on this story: Christopher Condon in Boston at ccondon4@bloomberg.net

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net

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