Knight Looks To Get $400M Infusion

Olly Ludwig and Cinthia Murphy

 

Knight Capital (KCG), the biggest ETF market maker in the U.S., is getting a $400 million lifeline in the form of a convertible preferred stock sale to several buyers, but the deal still needs a regulatory rubberstamp before it’s official.

While the sale would allow Knight to stay in business, it would also dilute the company as it would allow investors holding these convertible securities to buy Knight stock at $1.50, according to several media reports. Knight stocks closed Friday at $4.05, but was already trading nearly 32 percent lower around $2.76 in pre-market-hours trade Monday.

The preferred securities being sold would eventually convert into some 267 million shares of common stocks of the company. Jefferies ' Co., Getco, General Atlantic, Blackstone Group, TD Ameritrade, Stephens Inc. and Stifel Nicolaus are all said to be buyers, according to media reports citing a filing Knight submitted to regulators.

Knight stock surged 57 percent Friday as various brokerage firms resumed trading with the troubled firm after it managed to secure a line of credit, albeit temporary, that kept it in business for the day, but its troubles that started after a trading glitch involving its systems on Wednesday affected 148 stocks resulted in a $440 million pre-tax loss had already cost the company's stock price some 70 percent in value.

“The company is actively pursuing its strategic and financing alternatives to strengthen its capital base,” Knight said on Thursday in a press release, stressing that it will be business as usual for the company in the wake of the wayward trading episode. The company has yet to make any other public statements.

The swiftly moving story is one of the more astonishing developments in the world of electronic securities trading, where Knight plays a dominant role. The episode was centered on individual stocks, but affected some exchange-traded funds as well, notably the Vanguard Utilities ETF (VPU), which traded well above its net asset value in the crucial time period of the crisis between 9:30 a.m. and 10:15 a.m. Eastern time.

The drama took a turn for the worse for Knight as Thursday’s trading session unfolded amid reports that players in the ETF traffic were actively avoiding Knight at least until any outstanding trades clear.  Indeed, Vanguard, the No. 2 U.S. ETF sponsor by assets, told the financial television network CNBC that it was routing ETF-related trade away from Knight.

“For Knight, it’s pretty dire,” Scott Freeze of Street One Financial, said in a telephone interview.

“There seems to be a big concern about them being able to sustain themselves,” the president of the King of Prussia, Pa.-based ETF trading firm added.

Freeze said the problem is that Knight settles its own trades, and those that do business with it now fear that Knight’s compromised finances could mean it won’t be able to settle on any number of trades that were outstanding at the time its trading system became unhinged. Street One doesn’t settle its own ETF trades.

The point was driven home by a debt downgrade from Egan-Jones Ratings, which cut Knight’s credit rating to “CCC” after having cut it to “B-” earlier in the day. The ratings agency described Knight’s capital loss as “debilitating,” according to a Reuters report .

There was even talk about a possible bankruptcy filing, according to several media outlets, including the Wall Street Journal.

For the record, Jersey City, N.J.-based Knight said in the press release that while the whole episode “severely impacted” its capital base, its broker-dealer units remained in compliance with net capital requirements.

Sharks Circling

Industry sources say that whatever challenges Knight faces at this very moment pale in comparison to the attractiveness of its business—or at least particular pieces of it—to a party that has the resources to scoop up what is undoubtedly one of Wall Street’s most impressive market-making firms.

“Whoever has been dying to get into this business must be whetting their lips right now,” said one industry source, who spoke to IndexUniverse on condition of anonymity.

He said that many parties—from Wall Street investment banks to private equity firms—are likely to be interested in lending Knight a helping hand in order to gain a foothold in the business.

“If you’re looking to beef up your ETF business, you don’t want to buy all of Knight,” the source said.

While Knight’s capacity to provide deep markets in stocks and ETFs may be temporarily compromised because of the hit it has taken, the whole episode is likely to blow over sooner rather than later.

“If this has any effect on ETFs, it’s not likely to last very long,” Richard Keary, head of New York-based Global ETF Advisors LLC said in a telephone interview. Keary’s firm advises clients that are interested in bringing new ETFs to market.

 

 

ETFs Caught Up In The Weirdness

Nonetheless, Wednesday’s episode affected a few ETFs, such as Vanguard’s VPU--apparently because one of its constituents, Excelon Corp. (EXC), was caught up in the unhinged trading. EXC shot up Wednesday morning, and, it seems, took VPU up with it. The ETF's NAV was around $81 a share, but a number of trades were above that price—some at more than $84.92 a share.

The Market Vectors Gold Miners ETF (GDX) is another ETF that became untethered from its NAV during the episode, falling sharply during the episode.

Neither VPU nor GDX were on NYSE’s list of securities the exchange said it was reviewing, but EXC, the utility company, was.

So, while the unhinged algorithm at Knight doesn’t appear to have been explicitly linked to particular ETFs, Knight problems did bleed a bit into the world of ETFs. Knight, by the way, is the lead market maker on as many as 350 ETFs.

The Accident That Happened

On Wednesday, Knight saw its stock drop by a third as news spread about its wayward program-trading system. The episode was reportedly triggered by a human error that allowed for hundreds of trades to be executed in minutes instead of over a longer period.

“An initial review by Knight indicates that a technology issue occurred in the company’s market-making unit related to the routing of shares of approximately 150 stocks to the NYSE,” the company said in a prepared statement on Wednesday.

For its part, the New York Stock Exchange said separately in an  electronic communique that it was reviewing trades on 148 stocks for possible cancellation under its “clearly erroneous” rules. It later ruled that trades on six of those stocks were canceled.

The stocks with canceled trades were the following:

  • Wizzard Software Corp. (WZE), on trades at or above $4.68 a share
  • China Cord Blood Corp. (CO), at or above $3.22
  • Reaves Utility Income Fund (UTG), at or below $0.0497
  • E-House (China) Holdings Ltd. (ADR) (EJ), at or below $3.36
  • American Reprographics Co. (ARC), at or above $5.71
  • Quicksilver Resources Inc. (KWK), at or above $5.91

 

Market sources, who spoke to IndexUniverse on condition of anonymity, said that human error appears to have set the automated trading on its wayward course. Specifically, the sources said that a series of trades meant to be executed over a period of at least several days instead got executed within minutes.

“Everything we’ve heard is speculation, but what we have heard is that there was some sort of human error,” a trader said on Wednesday. “It seems to be some sort of accelerated (trade),” the trader said.

Not The ‘Flash Crash’

The limited scope of the problem makes the episode, at first blush, quite different than the “flash crash” of May 6, 2010.

On that day, the entire Dow Jones industrial average plunged by 10 percent, or almost 1,000 points, only to retrace most of those losses within 30 minutes before closing 3 percent lower. A large trade by a mutual fund firm set off the selling, during which market makers fled the scene, exacerbating the swiftness of the sell-off.

After the flash crash, about two-thirds of the securities with erroneous trades that ended up being busted by regulators were ETFs.

About a third of all equity trading now involves exchange-traded funds and, moreover, ETFs are a huge part of the electronic trading infrastructure that is becoming more and more prominent in modern financial markets.

Still, some like Freeze worry that electronic trading may be blamed, and not the lack of proper oversight.

 

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