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updated: 8/6/2012 12:46 PM

Knight avoids collapse with $400 million lifeline

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  • Knight Capital traders jacket hangs inside a post on the floor of the New York Stock Exchange after the close of trading Friday

      Knight Capital traders jacket hangs inside a post on the floor of the New York Stock Exchange after the close of trading Friday
    Associated Press

 
Associated Press

NEW YORK -- Knight Capital Group, the trading firm responsible for last week's stock market mayhem, avoided collapse by lining up a $400 million lifeline from a group of other Wall Street companies Monday morning.

But the money comes at a steep price.

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Knight says it will get the cash infusion from an investor group led by Jefferies Group, as well as Blackstone, Getco, Stephens, Stifel Nicolaus and TD Ameritrade. In exchange, the group will receive stock that can be converted to a 73 percent stake in Knight, which means Knight is essentially handing over control to the investor group. Knight will also add three directors to its board.

Knight's stock has mostly been in free-fall since a massive computer error in its systems last Wednesday sent huge numbers of erroneous orders flooding into the market, causing dozens of stocks to swing wildly in heavy volume. Knight said the foul-up would cost the firm $440 million as it paid for stock positions it mistakenly bought. Monday morning Knight's stock took another pounding, dropping 22 percent, or 90 cents, to $3.15. It closed last Tuesday at $10.33.

Knight's CEO Thomas Joyce, speaking in an interview on CNBC, said that only Knight, and not its clients, were hurt by Wednesday's snafu.

"This was an isolated situation," Joyce said. "We screwed up. We paid the price."

Joyce said his firm was still doing a post-mortem on the technical blunder and still didn't have a full understanding of what went wrong. He characterized the error as a "large" but "simple" breakdown on trading technology.

Knight Capital, based in Jersey City, N.J., is a trading firm that takes orders from big brokers like TD Ameritrade and E-Trade. It then routes them to the exchanges where stocks are traded, like the New York Stock Exchange.

Even with the cash infusion, it's not yet clear that Knight will regain the trust of other key players in the stock market to carry on and survive as a firm. Some of Knight's trading partners have said they would suspend routing trades through them until the situation settles.

One of the roles Knight plays in the stock market is that of a "designated market maker." Those firms are responsible for keeping trading of the stocks they oversee orderly. They are viewed as particularly important during the open and close of trading, as well as during times when there is a lot of volatility in the market.

Ten minutes before stock trading opened Monday morning, the New York Stock Exchange issued a press release saying it was temporarily reassigning Knight's responsibilities of trading 524 NYSE-listed stocks to Getco, a rival firm and also one of Knight's new owners.

In another troubling sign of financial market malfunction, trading on Madrid's stock exchange was suspended for five hours Monday because of a technical glitch. An exchange spokesman didn't provide any further details. Spain's stock market has been in turmoil for months as the country's banking system teeters on the brink of collapse following the implosion of a real estate bubble there. Spain's benchmark Ibex-35 index surged 4.4 percent Monday, its latest gigantic swing.

Knight's blunder has been a disaster for the firm's current investors. The value of the company's stock is now down 70 percent from Tuesday, the day before the blunder occurred. By issuing more shares, the value of what's held by current investors is diluted among more shareholders. It also means the company's earnings are spread among a greater number of shares.

When a public company sells such a big portion of itself, it's usually required to ask shareholders for their permission first. But the New York Stock Exchange granted Knight an exception, after Knight's board determined that waiting for a vote "would seriously jeopardize the financial viability of Knight," the company said in a news release.

The investor group will receive 267 million shares that they'll be able to convert to common stock for $1.50 a share. The firm currently has about 98 million outstanding shares, according to FactSet.

The Wall Street Journal reported that Knight asked the Securities and Exchange Commission, the federal regulator that oversees businesses, for an exemption so it wouldn't have to buy back so many of the mistaken trades, but the SEC declined.

Knight's CEO, Joyce, confirmed on CNBC that he did speak to SEC chairwoman Mary Schapiro over the weekend. "We had a frank discussion, and she did what she thought was right for the industry," Joyce said.

The SEC does allow trading firms to cancel some erroneous trades, but it has gotten stricter about what qualifies ever since the notorious "flash crash" of May 2010, when another technical problem sent the Dow Jones industrial average plunging nearly 600 points in five minutes.

Joyce said he respected Schapiro's decision but added: "This was an error, by any definition this was an error, so we would have liked to see some more flexibility."

The trading disaster Knight caused has revived a thorny debate in the financial system about the merits of high-speed trading, where lightning-fast mathematical algorithms trade stocks in milliseconds and, as recent mistakes indicates, strain the system that is supposed to handle them. More and more stock trading is handled by computers, and many market players have called for stricter controls to prevent disasters from happening.

Those problems, which have severely damaged confidence in financial markets, have been becoming more frequent. In May the highly anticipated market debut of Facebook was marred by a series of technical bugs. Technical problems at Nasdaq delayed the opening of trading by half an hour and kept many investors from knowing if their trades had gone through.

At that time, Joyce was one of the most outspoken critics of Nasdaq. Monday, he appeared humbled by his own firm's mistake, but was also adamant that the two situations were different.
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, Citadel LLC and Citigroup Inc., 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. 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."

--With assistance from Nina Mehta, Julia Leite, Steve Chambers, Stephanie Ruhle and Michael P. Regan in New York. Editors: Lynn Thomasson, Jeff Sutherland

To contact the reporters on this story: Inyoung Hwang in New York at ihwang7bloomberg.net; Whitney Kisling in New York at wkislingbloomberg.net; Lu Wang in New York at lwang8bloomberg.net

To contact the editor responsible for this story: Lynn Thomasson at lthomassonbloomberg.net

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