Knight Capital Group Deal: Conflict of Interest

Increasing order flow is vitally important to market makers and to high-frequency traders. Getco is both.

Unfortunately for the markets, there is an inherent conflict of interest between market makers and high-frequency traders.

Let's look at the New York Stock Exchange definition of a designated market maker (DMM):

"The Designated Market Maker (DMM) is at the center of the NYSE market and is the only participant to have true obligations for maintaining a fair and orderly market for assigned securities. DMMs must quote at the NBBO [national best bid and offer] a specified percentage of the time. They must facilitate price discovery during market openings, closings and during periods of substantial trading imbalances and high volatility."

Designated market makers must be the best bid and best offer in their shares a certain percentage of the time and must use their capital to provide liquidity when there are peaks of volume or volatility.

Now consider what high-frequency traders (HFTs) do.

Money Morning Capital Wave Strategist Shah Gilani has explained, "High-frequency traders employ pattern-recognition algorithms that look deeply at bids and offers on stocks to determine if the movement on the bid quotes or offered quotes implies a directional tendency.

"Computer-driven algorithms are "reading' the quotes, the intentions of buyers and sellers as they put down their orders in real-time, to make a trade that the HFT player expects to profit from if the directional bias their computers pick up is correct," Gilani continued.

HFTs are constantly sending out orders to buy and sell shares that they have no intention of completing. This "pinging" of the market is really an attempt at influencing the directional bias of a specific stock to create an opportunity to make a profit.

"HFT players are constantly pinging stocks where their quotes are housed and displayed," Gilani said. "They send out their orders to manipulate others to adjust their quotes, which get fed into the HFT algorithms to determine any directionality; then, if an opportunity exists, the HFT computers buy or sell shares that someone else has put onto the market."

Now here is where the real conflict of interest occurs.

"They aren't quoting constantly as bona fide "market-makers' are supposed to do," Gilani wrote. "They are simply putting out millions of fake bids and offers which they pull almost immediately, just to read the movement of other market participants who react to the HFT come-ons."

Why You Get a Bad Deal

Now that Getco has gotten Knight, they have access to 30% of the average daily volume on the NYSE from all sources.

This additional flow gives them more information about the true intentions of other market participants, creating new money-making opportunities for the in-house HFTs. That gives Getco an edge in the market and makes the market a lot less fair for the rest of us.

Of course, Getco's market-making arm is not supposed to give a "look" to Getco's HFT arm. Both are supposed to compete on an equal basis with other market participants.

But it is hard to escape the appearance of conflict of interest when HFTs account for so much of the market's average daily volume and when Getco can capture 30% of the market's average daily volume in-house.

When you add in the speed at which most trading takes place today - milliseconds or less - it further undermines the rationale behind the role of equity markets in a capitalist society.

Gilani continues, "What's undermining investor confidence in stocks is that it's all about speed and what Wall Street gets from having the advantage, and what games Wall Street erected to make money from the speed circuit that drives trading.

"It's about trading, not investing," Gilani concluded. "It's all about punching out what incremental gains you can in the short term, not about going the distance with safe investments in the long term."

Knight Capital Group was trading up nearly 6% to $3.53 in afternoon trading Wednesday.

Related Articles and News:

• Money Morning:
  The Real Story Behind the Knight Capital Trading Fiasco
• Money Morning:
  The Truth About High Frequency Trading and The Coming Market Crash
• Money Morning:
  Unless We Act, High-Frequency Trading Will Crash the Markets
• Money Morning:
  The Truth Behind the Tragedy of High-Frequency Trading
• CNN Money:
  Knight Capital to be bought for $1.4 billion
• The New York Times:
  Knight Capital and Getco to Merge
• Reuters:
  Getco to buy Knight Capital in $1.4 billion deal
• Newark Star-Ledger:
  Getco offers more cash in battle for Knight Capital takeover
• Crain's Chicago Business:
  Knight Capital board split on buyout offers from Getco, Virtu