NEW YORK—Shares in Jersey City-based Knight Capital Group (NYSE: KCG) traded down 63 percent Thursday as investors fear that the oldest and largest electronic market maker in equities will follow the same fate as MF Global and go bankrupt.
According to the company website, the “No. 1 market maker in retail U.S. equity shares traded,” which processed $19.5 billion worth of shares on average per day in June, recorded a $440 million pretax loss Wednesday in what appeared to be a software glitch.
Knight’s CEO Tom Joyce explained the issue in an interview with Bloomberg TV Thursday morning: “The software had a fairly major bug in it. … It sent into the market a ton of orders, all erroneous. So we ended up with a very large error position, which we had to sort through during the balance of the day.”
The company was preparing to connect its systems to the new NYSE’s retail liquidity program, which is where the mistake happened. The mistake had “nothing to do” with the NYSE according to Joyce and was purely due to their own system in what he described as a failure of software testing.
Market makers provide liquidity to the stock market as they simultaneously buy and sell securities at different prices. The positive difference between the bid price—the price at which the company buys from clients—and the ask price—the price the company sells to clients—constitutes the company’s profit from the trade; buying low and selling high. It aims to keep as few shares as possible of the underlying security, by trading in and out of positions fast and by hedging where appropriate.
Error Code Causes Company to Buy High and Sell Low
According, to Nanex, a company that develops technology to monitor quotes and trades in real time and analyzes trading anomalies on behalf of clients, Knight flipped this profitable formula Wednesday, buying at the ask and selling at the bid thereby giving free money away to its counterparties.
According to the Nanex website, “In the case of [Exelon Corp.], that means losing about 15 cents on every pair of trades. Do that 40 times a second, 2,400 times a minute, and you now have a system [that burns a lot of money].”
Nanex founder Eric Hunsader commented in a telephone interview with The Epoch Times, “I don’t think it was one thing, I think it was a [plethora] of different things going on yesterday.”
According to Nanex, who picked up the anomaly in different symbols within two seconds after market open Wednesday, this process went on for 30 minutes from 9:30 a.m. EDT Wednesday until 10:00 a.m. when Knight finally got the problem under control. Eric Hunsader said he was “shocked that there wasn’t an overriding [mechanism] saying, hey, there is something wrong, because we are generating a lot of losses.”
The New York Stock Exchange concluded its review of 140 stocks that exhibited strange trading patterns Wednesday and said that only 6 of them exceeded the 30 percent bandwidth that would prompt a cancellation of the trades. This leaves 134 stocks and an estimated 4 million of trades with small losses responsible for the $440 million loss of Knight Capital according to Nanex.
Hunsader said that “Knight should have caught it” but that afterward NYSE could not possibly have canceled those trades as the price movement was mostly within tolerable limits; it was just the pattern and the quantity that was astounding.
Knight Exploring Strategic and Other Financing Options
The loss, which is about four times the firm’s last annual profit, leaves a big hole in the firm’s capital, and Knight “is actively pursuing its strategic and financing alternatives to strengthen its capital base,” according to a press release.
Rating agency Egan Jones is downgrading the company to CCC from B- reasoning that “an equity or quasi-equity investment makes sense,” but notes that the company’s financial position is tough: “KCG probably needs $600 M of equity capital but its market cap is only $300M and therefore probably can only raise $80M to $90M using normal rules of thumb.”
Meanwhile, The Wall Street Journal reports that electronic trading firm Virtu is in talks with Knight over a potential merger or infusion of capital.
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