Will Knight rescue also save HFT reputations?

Knight Capital took a blow to its finances and reputation in August, but the US broker might boost the market standing of the high-frequency firm that wins the battle to acquire it.  

Knight Capital took a blow to its finances and reputation in August, but the US broker might boost the market standing of the high-frequency firm that wins the battle to acquire it.   

Rival electronic market makers GETCO and Virtu are among the bidders for Knight, the latter reportedly teaming up with private equity firm Cerberus Capital Management.

A takeover of Knight is on the cards after a series of technology errors contributed to a sinking of the firm’s share price. The broker first suffered US$30-35 million loss from the Facebook IPO in May following a technology error at Nasdaq OMX that left a number of investors unsure of their positions in the stock.

Then on 1 August, Knight was forced to seek refinancing from a consortium led by Jefferies and including GETCO, after a glitch in its market-making systems led to a crippling US440 million loss. GETCO already owns around 31% of the share capital in Knight, while Jefferies holds a 45% stake.

In October, Knight’s disaster recovery processes were found wanting as some servers failed to switch to backup systems during Hurricane Sandy, requiring the firm to ask clients to send orders to alternative destinations.

On 10 December, Knight shares were valued at US$3.24, compared to US$10.33 on 31 July, the day before the market-making glitch.

Knight shareholders are thought to prefer the Virtu offer, details of which haven’t been made public but is believed to be a cash-only deal. Other industry observers point out the private equity backing for Virtu’s offer suggests the deal will be a shorter-term ploy to grow and sell the entity.

As such, market participants have suggested the tie up with GETCO makes the best strategic sense for both firms, given the tough environment for electronic market-making firms.

In filing the bid with the SEC, GETCO said the merger would “unlock tremendous value for the shareholder of both firms while establishing a global leader in market making and agency execution”. GETCO’s part cash-part stock offer values Knight at US$3.50 a share, a 41% premium on the closing price of the firm on 23 November (US$2.49), the day before rumours of a potential merger surfaced in the press. Under the deal, GETCO CEO Daniel Coleman would be made head of the new company, with Knight CEO Thomas Joyce taking the role of non-executive chairman.

HFT’s rough ride

Adam Honore, Aite“It’s getting tougher and tougher to be a HFT firm these days,” Adam Honoré, research director at consultancy Aite Group, told theTRADEnews.com. “Asides from the lower volume environment, legislation around HFT activity is getting tougher and this deal offers both firms economies of scale.”

According to data from the Securities Industry and Financial Markets Association, the average number of shares traded per day in the first half of 2012 was 4.8 billion, compared to 2009 average of 6.9 billion.

In the US, the Securities and Exchange Commission now requires firms that offer sponsored access to invest in pre-trade risk controls and is also asking for more granular data reporting from HFT firms through the large trader reporting ID and the consolidated audit trail. Elsewhere, Germany recently approved new legislation that covers HFT firms for the first time, France introduced a tax targeting the practice, while on a pan-European basis, MiFID II is set to introduce new rules that could force HFT firms to act as market makers, ban maker-taker tariffs and harmonise tick sizes across trading venues.

Virtu has already bought Dutch market maker Nyenburgh this year, while a number of other HFT firms have reportedly scaled back operations.

Honoré believes the harsh environment for HFT firms will lead to a further M&A activity that bears similarity to the consolidation of discount brokers that followed the burst of the dot-com bubble.

Save and grow

For GETCO, a combination with Knight offers the opportunity to both broaden its business beyond its proprietary trading roots and reduce parts of its cost base.

The firms have substantial overlap in technology and infrastructure – such as market making software, telecoms and co-location cabinets – that will offer the opportunity for considerable cost savings.

In particular, retail market making is an area GETCO has attempted, but ultimately failed, to break into before. The purchase of Knight’s substantial and long-established retail execution businesses would help GETCO finally get a foothold in this area, alongside its long-term rival Citadel.

Similarly, Knight Direct – the firm’s algo execution business that was formed after the 2007 purchase of EdgeTrade – may provide a boost to the suite of algo tools that was recently launched by GETCO.

GETCO Execution Services offers the GETAlpha suite of algo strategies designed to deal with fragmented markets and deliver ‘micro alpha’ to institutional trading strategies.

But anecdotal evidence suggests buy-side traders are reluctant to place client business through GETCO because of its reputation as one of the largest and most prominent HFT firms. Moreover, Michael Blum, head of execution services at GETCO and the architect of GETAlpha, reportedly left the firm within the last month.

Knight Direct underwent a recent restructuring following the departure of Joe Wald, former head and co-CEO of EdgeTrade prior to the 2007 acquisition.

Brendan McCarthy, previously head of relationship management for Knight Direct, took Wald’s place and told theTRADEnews.com in September that he plans to focus the unit on technical and fundamental algorithmic research.

“We are making a huge effort to get in front of clients and show that we are not a ‘me-too’ player that offers benchmark strategies,” said McCarthy.

Knight also owns Hotspot, a FX trading platform is bought for US$77.5 million in January 2006.

While profitable, the Hotspot platform, which is believed to be worth US$350-400 million, will likely be too onerous for either GETCO or Virtu to run in addition to their existing capabilities.

“The sense was that Knight struggled to run Hotspot along with its other services and it seems likely that Virtu and Knight will face the same issues. I’d expect the eventual buyer to divest Hotspot,” said a US-based broker who spoke on the condition of anonymity.