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Knight Capital: Why You Should Care

August 03, 2012 – Comments (6) | RELATED TICKERS: KCG

Board: Macro Economics

Author: yodaorange

By now, I assume everyone knows about Knight Capital’s (KC) slight software bug that caused them to lose $440 million in 45 minutes yesterday (8/1/12). What you might not be aware of is the role that KC has in the US markets. Knight is one of the largest “market makers” and “designated market makers” (DMM) in the US. They handle roughly 20% of all equity trades in the US.

As an individual investor, if you place a stock market order through Fidelity, Vanguard, TD Waterhouse etc. chances are good that it is “routed” through KC. Understand that the brokerages do NOT interface and/or trade directly with the exchanges like NYSE, ARCA, NASDAQ etc. All of the brokerages go through a middleman like Knight.

Let me skip ahead and say that the Knight obituary is pretty much complete. Odds are they will either go bankrupt or be bought out in a matter of days. When they go BK, the question is what chaos will ensue.

We have two broad case studies to consider.

1) All of the bank closings done by the FDIC which are incredibly smooth and transparent to the depositors. The FDIC does a great job IMO handling these.

2) Unfortunately, the other case study is MF Global which I have described as a black swan event. I did NOT think it was possible in 2011 US Markets for a firm to make off with $1.X billion client dollars. We will leave out the fact that no charges have been filed as of yet.

I absolutely, positively do NOT think that any client funds will be lost when KC goes bankrupt. I also do not worry that eventually all of the securities you bought or sold will be properly accounted for.

What concerns me is how orderly the BK will be. As we saw when MF Global went BK and the music stops, there are an incredible number of loose ends left dangling. Eventually the SEC and the SIPC and the exchanges and the brokerage firms will get it all straightened out IMO. God only knows how long it will take. In the best case, it is 100% transparent to all individual investors.

In the worst case, your account could show the wrong quantities, cost basis etc. Also since you never know who has what money when the music stops, some of the brokerage firms might shortchanged for a while. Fidelity, Vanguard, TD Waterhouse and others have already stopped using KC.

BOTTOM LINE 1 is that in the end, I am confident that all will be well with individual investor accounts. Unfortunately based on a sample size of one (MF Global), I am not as confident that the process will be transparent to the individual investors. I would NOT change brokerages due to this. The brokerages did nothing wrong IMO

BOTTOM LINE 2 is that the software trading bug that occurred does not surprise me at all. I have posted several times previously that I expected other “flash crash” type events to occur again. All of the software developers on the board can vouch that software bugs are a fact of life. There is ZERO reason to think this is that last one we will see. The only question is when the next one will occur and how bad it will be.

BOTTOM LINE 3 is that I expect the SEC to show the same strong leadership as they have in the past. Meaning they will put Larry, Curly and Moe on the case right away. The chances of them doing anything significant to prevent another occurrence are about the same odds as Yoda beating Michael Phelps in a swim race.

Thanks,

Yodaorange