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What Really Happened at Knight Capital

32 | By Shah Gilani

Oh, you are going to love this.

That whole Knight Capital fiasco on Wednesday, when a software glitch caused them to flood the market with thousands of unintended orders, it ain’t exactly what you think it is.

Sure, they tripped over themselves in the dark pool where they were trying to compete.

But somewhat interestingly (okay, a LOT interestingly), the competitor that drove them to “upgrade” their trading software, which malfunctioned and caused them to actually bid-up share prices erroneously and then buy them at inflated prices, was none other than, wait for it…

The New York Stock Exchange.

That’s not the whole story, or even the good part. Oh, it gets better. A lot better.

Knight claimed a $440 million trading loss on Wednesday resulted from their computer glitches and sunk the company (at least for now; I’ll get to that).

Well, according to Nasdaq (this was on its site: nasdaq.com), it wasn’t a trading loss at all. Knight paid Goldman Sachs a $440 million fee (commission?) to take the errant shares Knight had bought on Wednesday morning off its hands.

Now, I don’t know what Goldman did with those shares, but my guess is they held most of them and sold them on Friday when the market soared a few hundred points. Of course, that’s not a “prop” trade. Knight is a customer of Goldman’s (it is now…).

But who cares?

Goldman Sachs ripped a customer for a $440 million fee, virtually bankrupting it in the process, flipped the shares it bought from Knight to “help” them (and first of all, probably overly hedged itself… as in enough to be net short… the large stake it holds in Knight’s convertible preferred) for a tidy profit, and then probably shorted the stock (before “helping” them, and themselves to their little fee) before the stock collapsed, then probably gave it its “lifeline” (that’s a guess, and I’m being sarcastic, but it’s possible). And maybe we’ll find out where that lifeline Knight got on Friday really came from) before buying a ton of Knight’s shares back on Friday before hearing (of course… before) that several big firms were looking at buying Knight.

What’s my point in the above LONG sentence? Who cares! That’s all business as usual at the Golden Vampire Sachs.

That’s after-the-fact stuff.

What’s more interesting is why all this happened in the first place.

Here’s what you probably don’t know…

Back in July, the NYSE got permission (from the SEC… oh, those guys are good) for a one-year pilot program. The name of the program is… wait for it… the “Retail Liquidity Program.”

Are you laughing? You will be.

The Retail Liquidity Program allows the NYSE to transact on the exchange (its Exchange), for the benefit of retail customers only, at better than posted prices.

That’s right. If you’re a retail investor and you buy or sell a stock on the NYSE, you might get a price better than the bid, if you’re selling, and a price better then the offer, if you’re buying.

Mind you, it’s not much. Maybe one-tenth of a cent. But hey, you know, on your 100 share orders, that adds up to a lot of money. Maybe now you can afford that Rolls Royce.

You didn’t know that, did you? And why should you? You wouldn’t because YOU don’t transact on the NYSE. YOU don’t send your orders anywhere.

Here’s what’s happening behind the scenes…

When you place an order with, say, TD Ameritrade, or Scottrade, or Fidelity, or E*Trade (these are all customers of Knight Capital; I’m getting to that), they “route” your orders to be executed against bids and offers elsewhere. Those bids and offers may be on the NYSE, at some bank (maybe Goldman Sachs), on some market-maker’s trading desk (like Knight Capital’s desk… they’re a market-maker, you know), or in some dark pool, or at some other hole in the system where trades slip into darkness.

Your broker routes your trade for execution to some destination, because he is paid to send it there. That’s right; your broker is paid to send your order somewhere, and if it’s an NYSE-listed stock, it probably won’t even be sent to the NYSE.

That’s because the NYSE doesn’t pay for “order flow.” Oh, wait a minute…

They do now.

Under their Retail Liquidity Program, they can now pay for order flow, kind of. They get orders directed to them by offering a slightly better price on an execution than is posted on their own Exchange.

The idea is that they can’t compete with companies like Knight, who pay for order flow (so it never gets to the NYSE) and take the other side of trades or match them off against other order flow in their systems, or other people’s systems.

I know this is a little confusing. But here’s what you need to know.

This whole “paying for order flow” thing is about collecting as many orders as you can get under your roof. The more orders you see coming your way, the better you know what the bids and offers are out there, the better you can “predict” prices, and the more profitable your trading will be… that is… if you’re high frequency trader, or a market-maker… like Knight.

So, the NYSE gets to compete with Knight. And Knight doesn’t like that. So, it upgrades its software to jump the NYSE. And it blows up.

Knight’s systems (probably “pinging” and looking to influence market prices and initiate trades) sends out orders (I’m speculating here), which end up lifting bids, which ends up triggering Knight to buy shares, which ends up being a huge cluster you-know-what, because it’s all a mistake, you know. Which means they own a bunch of stocks they don’t have enough capital to hold. Which means Goldman Sachs gets to bend another customer over.

Which means everything is normal on the Street.

I can’t wait for Monday.

You just can’t make this stuff up.

Shah

32 Responses to What Really Happened at Knight Capital

  1. Frank B. says:

    As usual Shah, You’ve hit the nail on the head!
    Too bad so many people have their heads stuck in the sand and can’t hear you!!

    Love ya, keep on keeping on!

    FB

  2. Steve Lombardi says:

    So do I understand this right? They are betting (investing) against their own customers and using our orders to predict which way they should go (long or short), all without providing us with the “advice” we are paying for; or are we?
    Hmmmm…. and they wonder why retail investors are losing confidence in this system? I’ll repeat what I say to the lawyers, “If you want to know why they hate us, just look at the way the system is operating.”
    I rest my case.

  3. Philip Evan Hope says:

    Wow!The lengths they can go to, are allowed to go to, will go to, and do go to!!!!
    Would you say that the sophistication of advanced high-frequency trading programs have changed all the rules (figuratively), and therefore we need a whole new set of rules governing them (literally). This high-frequency trading seems to me as impossible to keep from being continually abused as obvious/blatant market manipulation. It is going to end like the ‘Grinch who stole Christmas’..eventually there will be no money left to take and therefore no prosperity, no growth, no capital gain for the future. You would think that even the greediest of fools/bands of fools would realized that killing the market and making a killing in the market have become one and the same death dealing practice. The only guys making a killing on the market today are the guys actually killing the market to do so. That’s bad business.

  4. Janet Norcott says:

    Re: Shah Gilani’s article entitled What really happened at Knight capital. So with all of the games played on Wall Street and in government, does the Middle class American have a chance?

  5. Neil Morrison says:

    Shah are you suggesting a buy on this stock? i watched this on Friday for the last 4 hrs and had i bought would have turned a nice profit however something said wait .Monday let me put you on the spot up or down for Night Capital and if up do you see a take over and a return to the 10 dollar price or is it all a bit risky.

  6. Glenn says:

    So now the computer software is the finial nail in the coffen, thats good news for traders & bad news for the computers,but they will just go and up grade there software if the still have a shirt.So long Knight.

  7. gemmoo says:

    Incidents like this call into question some very basic concepts about the American financial system such as “What is a market?” and “How does price formation work?” It seems to me that we have lost sight of these very basic concepts that underpin the financial system. Back in The Day, when all trading in NYSE stocks had to take place on the NYSE, it was very easy to answer these questions and the result was that all investors, large and small, had more even-handed access to the market. Was it more expensive? Yes. Was it less efficient? Yes. Could you trade baskets of shares? Not easily. Did high frequency trading exist? No. Did the intervention of human traders on a trading floor prevent order entry errors from manifesting themselves as “flash crashes?” Every day of the week.

    As a Wall Street veteran with nearly 40 years of experience, it seems to me that we have to re-examine some of the core concepts that underly Wall Street. No one trusts the Street anymore and for good reason. Individuals and even institutions do not feel that the market is fair in the way prices are are formed and transactions allocated–the most basic functions of a market.

    Are we really better off today than were were a couple of decades ago? Maybe it is time for a “Constitutional Convention” for the financial markets to debate the most basic concepts of what a market is and how it is supposed to function before the people lose faith in the sysdtem entirely. Or is it already too late?

  8. Not Quite So Cynical says:

    Shah, Over the last 20 years, I have worked with Edward Jones, Merrill Lynch, UBS, and for the last year I have my own firm. Your statement:

    “Your broker routes your trade for execution to some destination, because he is paid to send it there. That’s right; your broker is paid to send your order somewhere”

    is completely incorrect. The client’s broker has zero to do with that.

  9. JB says:

    Shah: we does a small investor with limited funds go to invest in the market? I was on the verge of sending money to E-Trade. However, if E-Trade is not operating in the best interest of me (foolish to hope for–I know) then I don’t feel like giving them my business. There MUST be other games in town that are played a little more fair (foolish word–I know). Thanks for your insight—and I keep PRAYING for indictments (foolish–I know).
    JB

  10. Gc says:

    And that’s why most investors are keeping their investments out of stocks… And no-one is questioned? Nor the system itself? It would seem they all are out to make ascmuch money as possible before the curtain falls, whatever that may be in real terms.

  11. terry l. thomas says:

    So what? This was going on before the Glass-Steagall act was passed and since it was with the connivance and assistance of the banking and investment industry that Glass-Steagall was preventing them from competing in the world market they convinced our politicans to repeal it. Welcome back to the 1920’s.

    The only thing missing is Al Capone and his crew. OOPS – my mistake, they’re now wearing $1,000. Armani suits, etc. and operating as responsible bankers and investment firms.

    BRING BACK & ENFORCE THE GLASS-STEAGALL LAW, NOW!

  12. Josh Owen says:

    I dont understand what is wrong with this? It’s all apart of the game. Everyone is looking for a leg up. Everyone will take an opportunity to get a better deal the guy beside him. As individual investors we are like minor league players trying to take on the guys in the majors. Its the risk we choose, and are willing to take. If its not breaking the law then the play is legal in my opinion. Goldman may be “vampire sachs” but everyone who does business with them knows their reputation. I guarantee you Knight did not get blind sided by Goldman, and if they did then they were ignorant.

  13. Reverend Alpha says:

    Won’t post criticism, eh? Tells me a lot about the quality of your work and motivations. Financial professionals who create a facade of infability are often charlatans and hucksters. Ray Dalio, one of the greatest investors of our lifetime, embraces errors and mistakes. You should too. They’re invaluable learning opportunities.

  14. gkm says:

    You lost me at “lifting bids”. If you don’t even know the vocabulary, you probably don’t know much.

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