Knight's armour loses its shine

As Knight Capital comes to terms with massive losses due to its software glitch, market participants are worried the failure will damage already fragile investor confidence.

Financial markets have been given a chilling reminder of the flimsy nature of their underpinnings, with US broker, Knight Capital battling to survive after a computer glitch last week left the broking firm saddled with $440 million in losses.

According to the latest reports, Knight’s survival hinges on it striking a deal with a consortium including the discount broking firm TD Ameritrade Holdings and the electronic trading firm Getco. The consortium would inject about $400 million into the New Jersey-based Knight, heavily diluting Knight’s existing shareholders.

Knight – which in the past decade has become a leading broker for US stocks, responsible for about 10 per cent of all trading on US equity markets – saw its share price plunge from around $10 at the beginning of the week to a low of around $2.60 on Thursday after the firm disclosed that its newly-installed software system had sent "numerous erroneous orders” in New York Stock Exchange–listed securities into the market. Knight’s share prices rebounded on Friday after Goldman Sachs intervened to help the broker unwind its erroneous trades by buying the shares at a discounted price.

Knight’s problems began on Wednesday morning when newly-installed software began spewing out a torrent of faulty trades. But even though the NYSE notified Knight of the erratic trading within minutes of the open, the firm was unable to stop the trading program for more than half an hour. During this time, the firm amassed $440 million in losses, and the share prices of nearly 150 companies – mainly small and mid-cap stocks – were roiled.

In the wake of Wednesday’s problems, some of Knight’s largest customers, including the giant asset manager Vanguard, and E*Trade and TD Ameritrade shifted their trading to other brokers. On Friday, TD Ameritrade said it was resuming its relationship with Knight, but other large clients have yet to return.

Market participants worry that the latest problems with Knight – which has picked up numerous awards for its high-speed trading systems – will further dent already fragile investor confidence.

In recent years, financial firms have embarked on a 'high frequency arms race' – based on using high-speed computers to trade using complex algorithmic formulas. The aim is to hire top-level math geniuses to develop a complex formula that arbitrages slight differences in stock prices, and to ensure that the trades are executed within milliseconds. These systems are then set loose on the market, and frequently generate huge profits for the financial firm.

But there are fears that this 'high frequency trading’ – which is now estimated to account for 50 per cent of all trading on US share markets, is scaring off ordinary investors. High-speed computerised trading was the chief culprit in the May 2010 'flash crash', when startled investors saw US shares plunge sharply and without warning, only to rebound within 20 minutes. And, although regulators subsequently introduced circuit breakers to prevent a repeat of the flash crash, investors were again unnerved by the software glitches that plagued the Facebook initial public offering.

NYSE boss Duncan Niederauer last week acknowledged that there was now a "crisis of confidence" among investors, and said the latest Knight incident was "another example of the fact that the US market structure evolution has led to inexorable fragmentation and an emphasis on speed.”

But few believe the US Securities and Exchange Commission will step in to stop the spread of high-speed trading. Although SEC boss, Mary Schapiro, said the Knight incident was "unacceptable’, she signalled that the regulator’s main concern would be on whether Knight’s systems were operating properly, rather than whether a major overhaul of the market was needed.