Knight Investors Eye Prize in Market-Making

Photographer: Jin Lee/Bloomberg

A trader works at a Knight Capital Group Inc. post on the floor of the New York Stock Exchange (NYSE) on Aug. 3, 2012. Close

A trader works at a Knight Capital Group Inc. post on the floor of the New York Stock... Read More

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Photographer: Jin Lee/Bloomberg

A trader works at a Knight Capital Group Inc. post on the floor of the New York Stock Exchange (NYSE) on Aug. 3, 2012.

The investors who bailed out Knight Capital Group Inc. (KCG) by purchasing $400 million in convertible securities are gaining control of the biggest trading partner for individuals in the world’s largest stock market.

While last week’s $440 million trading loss highlighted Knight’s importance to institutional traders, the company accounted for 29 percent of the average monthly volume in U.S. equity trading by individuals in the first quarter, according to a June 7 presentation. Stifel Nicolaus & Co. and TD Ameritrade Holding Corp., two of the firm’s rescuers, sent 38 percent and 9 percent of market orders in New York Stock Exchange-listed securities to Knight last quarter, respectively, according to public execution-disclosure statements.

Knight was saved from insolvency by Getco LLC, Blackstone Group LP, Stephens Inc. and Jefferies Group Inc., as well as Stifel and TD Ameritrade, according to people familiar with the matter who asked not to be identified because the agreements aren’t public. Knight’s mishap sent 140 stocks into sudden swings at the Aug. 1 open, the latest breakdown to challenge the integrity of the world’s biggest stock market.

“Investors in Knight are getting a stake in a company with several very attractive assets at what might turn out to be a very attractive price,” Patrick O’Shaughnessy, an analyst at Raymond James & Associates Inc., wrote in an e-mail yesterday. “Knight plays an important role in U.S. equities market structure and retail brokers have a vested interest in making sure competition for their order flow remains robust.”

Convertible Stake

The rescue involves a $400 million cash infusion through the sale of convertible preferred securities, according to a regulatory filing today. The 2 percent securities will be converted into 267 million shares, according to the filing. That would represent a 73 percent stake in the company, according to data compiled by Bloomberg.

Knight shares plunged 32 percent to $2.75 at 7:46 a.m. New York time in trading before U.S. exchanges opened.

Market-making operations at Jersey City, New Jersey-based Knight generated between $200 million and $255 million in annual pretax income from 2009 to 2011, Christopher Allen, an analyst at Evercore Partners Inc. in New York wrote in an Aug. 2 note.

Kara Fitzsimmons, a Knight spokeswoman, declined to comment before the release of the filing. Fred Tomczyk, TD Ameritrade’s president and chief executive officer, declined to speak as he left Knight’s headquarters in Jersey City, New Jersey yesterday.

Sophie Sohn, a spokeswoman for Chicago-based Getco, declined to comment. Representatives for Stifel, Blackstone, Stephens and Jefferies didn’t respond to calls and e-mails seeking comment.

Core Foundation

Knight is the dominant firm in equity wholesaling, the business of executing orders off exchanges primarily for brokerages such as Scottrade Inc. and TD Ameritrade, according to Larry Tabb, chief executive officer of research firm Tabb Group LLC in New York. Its main competitors are UBS AG (UBSN), Citadel LLC and Citigroup Inc. (C), Tabb said.

“A large portion of their business revolves around the wholesaling business and market-making business,” Tabb said. “That was the core foundation.”

Eight brokers with “significant retail customer accounts” send almost all of their orders that can be executed immediately to market makers executing off exchanges, the SEC said in 2010. Those firms pay many of the brokers sending orders less than 1/10 of a cent per share for the orders. Orders traded on exchanges can pay fees of up to 3/10 of a penny.

Order Flow

Individual investors that send orders through discount brokerages can benefit from having their trades routed off exchanges, Robert Colby and Erik Sirri, former officials at the Securities and Exchange Commission who ran the regulator’s division of trading and markets, wrote in a 2010 paper. The process, known as internalization, can allow brokers to get better prices for clients of discount firms and help them keep trading costs low, they said.

Knight participates in a practice known as payment for order flow, in which it compensates retail brokerages for sending it requests to transact securities. The company paid a total of $85.3 million to retail brokers for their order flow in 2011, up from $37.7 million in 2010, according to its annual report last year.

“What you don’t want to see is losing one of the major participants in the market,” Mark Freeman, who oversees about $13 billion as chief investment officer at Westwood Holdings Group Inc. in Dallas, said in a phone interview. “Someone may say, ‘Hey, these orders just get routed to someone else,’ but it still matters how many participants you have. We see this in the bond market in terms of primary dealers. The fewer you get, liquidity becomes more of an issue.”

Losing Faith

Knight’s errors and the other trading mishaps underscore why American investors have pulled $193 billion from mutual funds since the start of 2011. The value of transactions in exchange-traded funds tracking the Standard & Poor’s 500 Index is poised to exceed for the first time the turnover for all the stocks in the benchmark gauge.

While stock transactions in the U.S. used to be dominated by three exchanges, regulations to increase competition and reduce costs have fragmented markets across about 50 different venues. That’s raised concerns about integrity in the $16.4 trillion market when the computers that now handle almost all trading malfunction.

Knight Chief Executive Officer Thomas Joyce said the problems were triggered by “a large bug” in software as the company, which handles about 10 percent of market making in U.S.-listed stocks, prepared to trade with a NYSE program for individual investors. While that system began the day of Knight’s trading error, Joyce said the technology problem had “nothing to do” with the Big Board.

Negative Sentiment

“It further contributes to the negative sentiment in the equity market, particularly among retail investors,” Joe Scott, a New York-based credit analyst at Fitch Ratings who covers banks, said in a telephone interview. “They’re very active with the discount brokers and making markets in equities. They’re intertwined with the rest of the financial system.”

Volume in U.S. exchange-listed stocks is already headed for a third straight annual decline. About 6.7 billion shares changed hands each day on average in 2012, 25 percent less than in 2008, based on data compiled by Bloomberg of U.S. exchange- listed securities. Volume fell 9.9 percent in July from June, after a 3.2 percent drop in June from May, the data show.

Malfunctions Multiply

The software malfunction may worsen investor sentiment hurt by the so-called flash crash in May 2010, when a trading error briefly wiped out $862 billion of market value, the botched initial public offering of Facebook Inc. (FB) and failed IPO of Bats Global Markets Inc. earlier this year. Two weeks ago, investors in three of the biggest Dow Jones Industrial Average stocks were whipsawed by price swings that repeated every hour, fueling speculation the moves were caused by computerized trading.

Securing additional capital to fund businesses such as market making was viewed as necessary to keep Knight afloat. Analysts at CLSA Credit Agricole Securities wrote last week that bankruptcy was a possibility if it failed to get financing. Knight’s loss was bigger than the $365 million cash balance it reported as of June 30 and exceeded its market value of $398 million as of Aug. 3, data compiled by Bloomberg show.

“This is one of our largest and best-run market making outfits,” James Angel, a professor at Georgetown University’s business school in Washington who serves on the board of exchange operator Direct Edge Holdings LLC, said in a phone interview. “It definitely shows signs of confidence in Knight and its management that people are willing to step forward with this kind of a cash infusion.”

To contact the reporters on this story: Inyoung Hwang in New York at ihwang7@bloomberg.net; Whitney Kisling in New York at wkisling@bloomberg.net; Lu Wang in New York at lwang8@bloomberg.net

To contact the editor responsible for this story: Lynn Thomasson at lthomasson@bloomberg.net

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