August 8, 2012

Knight Time

Some were forced to do it themselves.

In the wake of Knight Capital’s technology glitch – if you missed it, a linchpin in trading markets was nearly undone Aug 1 by faulty trading software – some brokers who normally route order flow to Knight for handling had to execute their own trades.

They’re not as good at it. No question. But a curious thing happened. We observed a measurable increase in share of market for rational money. More volume acted like rational investment the days following.

Why? How? Today, money often puts compliance before investment considerations. Say you’re a mid-tier broker-dealer whose client is a small Midwest municipal pension fund. The fund puts a modest percentage of resources into a trading portfolio and directs trades to you because your firm’s president golfs Fridays with the mayor.

Before we continue, breaking news: I’m in New Orleans next week to sit down with JOE SALUZZI, co-author of Broken Markets, for a candid chat on what ails markets today. I’m also moderating a wild brawl of a panel discussion on the hot topics in IR today. If you’re not in the Big Easy next week, well…you’re not where you should be.

Back to our story. Market rules require that you as a broker execute trades in something similar to the amount of time that Morgan Stanley does, which is hard to do without more risk to your firm’s capital base (meaning your money takes the other side of trades if nobody else is there). Face it. A family brokerage in Bloomington, IL, isn’t going to host its servers right next to the Nasdaq’s in Trumbull, CT, like Morgan Stanley.

So what do you do instead? You route your orders to Knight Capital, which pays you for them because aggregate volume earns a trading rebate from the NYSE or another market center. Knight absorbs the trade-execution compliance worries for you. And you can still charge the pension fund something for the trade. It’s not riches, but it works.

And then suddenly, Knight’s in the hospital. Cripes, what to do? Maybe you have to dust off the old trading terminal and do it yourself. Suddenly, you’re buffeted by the winds, rocked by the waves. You’re out there in the crazy badlands, trying to fill orders against the likes of Hudson River, RGM, Two Sigma, heck, even Barclays, UBS and Citi. It’s war.

And a crazy thing happened on the battlefield. All the rest of those big orders, those big machines, that thundering artillery – well, it acted like you knew what you were doing. And it followed you. Because your orders didn’t behave like the rest.

Look, we’ve taken license. But we wanted to make a point. The data conclusions are what they are. In the wake of Knight’s troubles – which the firm blessedly has met with verve and surmounted, a testament to its standing among peers – rational market share increased by measurable amounts. We can only attribute it to what we fictitiously described above.

It’s a lesson for regulators. Humans deal with crises. It’s what we do. Don’t think you have to do it for us. Markets would be better, freer, safer, with fewer tangled rules to navigate. Maybe little brokerages in Bloomington, IL, would thrive again. Public companies need small brokers, small investors, diversity in orders. Sameness turns individuality of results into algorithms and ETFs.

Concluding word to the wise on markets: Stocks are up on a weak dollar. It’s synthetic – the result of relative value, not fundamentals. Beware that this move will last for as long as the Germans buy the Italian job.

I’ll leave it you to figure out what that means.

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