March 24, 2023

DealBook: Trying to Be Nimble, Knight Capital Stumbles

Traders from the Knight Capital Group watched from the floor of the New York Stock Exchange as Knight's chief, Thomas Joyce, was interviewed on television.Brendan McDermid/ReutersTraders from the Knight Capital Group watched from the floor of the New York Stock Exchange as Knight’s chief, Thomas Joyce, was interviewed on television.

As the leader of one of the largest brokerage firms in the nation, Thomas M. Joyce has been an unapologetic advocate of electronic trading and one of the most vociferous critics of companies that struggled to keep up with the ever-changing stock market.

Now, Mr. Joyce, a longtime trader who seized the reins of the Knight Capital Group in 2002, is fighting for his company’s survival.

In a bid to keep a grip on its customers, Knight pushed to introduce a new system that would position it competitively amid market changes that took effect on Wednesday, according to people briefed on the matter. Unlike rivals that hesitated, Knight Capital’s presence on Day 1 would ensure bragging rights and extra profits.

But in the rollout of the system that morning, Knight created a blizzard of erroneous orders to buy shares of major stocks. The orders caused wild swings that affected the shares of more than 100 companies, including Ford Motor, RadioShack and American Airlines.

While the companies quickly recovered, the 17-year-old Jersey City firm was left reeling. Knight will lose $440 million in selling all the stocks that it accidentally bought on Wednesday — more than its entire revenue in the second quarter of this year, when it brought in $289 million.

Timeline: Trading Errors

Knight Capital, in a bid to keep a grip on customers, rushed to introduce a new system that would position it competitively.Mel Evans/Associated PressKnight Capital, in a bid to keep a grip on customers, rushed to introduce a new system that would position it competitively.

On Thursday, rattled customers like Citigroup, Fidelity Investments and Vanguard took their business elsewhere. Knight shares plunged 63 percent, to $2.58. The fallout prompted the company to contact JPMorgan Chase and other big banks for emergency financing.

The company is also facing an onslaught of regulatory scrutiny. The Securities and Exchange Commission’s enforcement division is examining potential legal violations, people briefed on the matter said.

As it faces the flight of confidence, Knight is desperately seeking potential buyers for parts of its business. On Thursday, Knight’s senior executives reached out to hedge funds and rivals like Citadel and Virtu Financial, according to people briefed on the matter. But by day’s end, interest was uncertain and there were questions about whether the company would collapse into bankruptcy.

“With the events of yesterday, you have to question if this is the beginning of the end for Knight,“ said Christopher Nagy, founder of the consulting firm KOR Trading.
Knight Capital declined to comment.
Within the company, the mood grew grimmer as hopes for a recovery dwindled, according to traders at Knight, who were not authorized to discuss the matter. Some employees slept at the company overnight on Wednesday.

“I am grateful that at this point I still have my job,” one trader said.

Originally named Roundtable Partners, in a nod to Arthurian legend, the trading company rose to prominence with the proliferation of high-speed electronic trading. In the first half of the year, Knight accounted for 11 percent of all stock trading in the United States, according to the TABB Group.

The pressures to stay competitive, however, meant that the time between developing new trading software and putting it in use became shorter and shorter.

On Wednesday, the New York Stock Exchange began a program intended to loosen the stranglehold that brokerage firms like Knight had over retail investors. Under this program, trades from retail investors now shift to a special platform where trading houses compete to offer them the best price.

Knight sought to stay nimble. Over the last several weeks, the company tweaked its computer coding to push itself onto the new platform.

Two competitors who declined to be named because they didn’t want to publicly criticize a rival said that they took a more measured approach, choosing not to create new software to coincide with the debut. Some also questioned Knight’s aggressive approach.

“The time between the approval of the software and the time it was implemented was incredibly quick,” said a head of equity trading at another firm.

The errant trades on Wednesday quickly seized Wall Street’s attention. Within seconds of the New York Stock Exchange’s opening bell ringing at 9:30 a.m., Knight’s computer coding malfunctioned.

The code was supposed to direct the firm’s computers to react to trading. Instead, it placed its own runaway offers to buy and sell shares of big American companies, driving up the volume of trading to suspicious levels.

Officials at the exchange began noticing an enormous spike in volume shortly after the opening bell. Exchange officials soon touched base with the S.E.C. in Washington, where an internal e-mail system alerted regulators to the problem. A regulator stationed in the agency’s market watch room sent out regular alerts to senior agency officials.
Within minutes, the authorities traced the problem to Knight.

Yet even after that detection, the New York Exchange had limited authority to take action. Most measures that curb erratic trading are tied to wild swings in stock prices, whereas the problem at Knight was initially tied to the volume of trading and not the price of shares. In addition, circuit breakers that halt individual stocks do not work during the first 15 minutes of trading.

About 45 minutes into the debacle, the exchange shut down Knight’s trading.

By the end of Wednesday, there were winners and losers.

Many big investors cashed in on the market volatility. They saw what was happening when the surprisingly large trades began to register, and they quickly moved to profit from the disruptions.

The winnings were spread from individual traders to proprietary firms that use specialized computer algorithms to spot and profit from market aberrations, including the DRW Trading Group. Hedge funds and other asset managers that trawl the market looking to profit from abnormal pricing also won big.

But while many institutional traders managed to profit from the fiasco, individual investors did not fare as well.

“It’s the retail investor that gets hurt because they are not sitting in front of a computer watching the market all day,” said Scott Freeze, president of Street One Financial, a trade execution firm.

In the aftermath of the bruising day, the S.E.C. is taking a closer look at Knight’s decisions. The agency is examining whether Knight properly tested the coding change — and whether it had sufficient internal controls to avert such a disaster. Some regulatory officials, however, commended Knight for steering customers to other brokerage firms.

On Thursday, S.E.C. examiners remained on the ground at the brokerage firm. Mary L. Schapiro, the agency’s chairwoman, spoke with Mr. Joyce Wednesday afternoon.

Ultimately, the debacle is a significant blow to Mr. Joyce, 57, whose ambition came to define the rapid rise of the firm.

Mr. Joyce, who made his name at Merrill Lynch and Sanford C. Bernstein Company, was a trusted ambassador of electronic trading. On June 20, he testified before a House Financial Services subcommittee, arguing that the booming business democratized a stock market once dominated by a handful of Wall Street firms.

He was also seen as an eager critic of other firms’ missteps. In recent months, he excoriated Nasdaq for bungling the stock market debut of Facebook, which cost Knight $35.4 million.

“This was arguably the worst performance by an exchange on an I.P.O. ever,“ he said in an interview in May with CNBC.

When Mr. Joyce took control of Knight in 2002, he was tasked with cleaning up the firm.

In 2004, Knight agreed to pay $79 million to the Securities and Exchange Commission to settle accusations that it “defrauded” customers. Knight did not admit wrongdoing.
Just last month, however, some outside traders indicated they experienced problems when routing trades through Knight Capital. Craig Warner, head of trading at Capstone Investments, a research boutique firm, said that a few weeks ago an order he placed with Knight went wrong. The trade was supposed to be spread throughout the entire day, but a half-hour before the market close, the remainder of the trade was executed all at once.

“It was alarming because if the stock had been really moving, it could have been a big problem,” Mr. Warner said. “After having the issue I had last week and with the issue yesterday, I lost a lot of confidence in them,” he said, adding that he was no longer using Knight to clear trades.

Even on his first day at Knight, Mr. Joyce was greeted by irregular trading. On June 3, in 2002, the company’s stock was suspiciously trading at 14 cents, after a software malfunction misread a Knight trader’s order. Instead of placing an order to sell roughly one million shares of a penny stock, the system sold the firm’s own stock.

In an interview with Institutional Investor magazine, Mr. Joyce recalled getting on the intercom that day and introducing himself to his staff. “I’m Tom Joyce, he said, “and yes, I know that our stock is trading at 14 cents.”

Azam Ahmed, Michael J. de la Merced and Nathaniel Popper contributed reporting.

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