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Why Market-Making Giants Want Knight Capital Group

Knight Capital Group (NYSE: KCG), which had to be rescued after it went belly-up in August following a $440 million loss later blamed on a "computer glitch," is expected to entertain takeover bids from interested parties this week.

Yesterday, high-frequency trading (HFT) giant Getco Securities, which already owns a 23.8% stake in Knight Capital, offered a combination of cash and shares valuing Knight at $3.50 per share, a 17.8% premium to Tuesday's close. Knight's share price rose 15% in trading yesterday in reaction to the bid, which was acknowledged by Knight management.

"I am convinced that this merger would unlock tremendous value for the shareholders of both firms while establishing a global leader in market-making and agency execution," Getco CEO Daniel Coleman said in the letter to Knight's board.

Another high-frequency trading firm, Virtu Financial Capital Markets LLC, reportedly plans to make an all-cash offer at $3.00 per share, according to FOX Business Network.

Wednesday's share-price rally was Knight Capital's biggest in nine years, as it could be about to be the focus on a bidding war between HFT firms.

Why Knight Capital is a Hot Target

Knight Capital Group is one of the largest market-makers, or broker's broker, in the United States.

Other stock brokers route trades to Knight for execution. Knight collects these trades and matches buyers with sellers. Knight is said to transact about 10% of all of the volume traded on the New York Stock Exchange daily.

In the olden days, this was done by traders, known as specialists, who specialized in making markets in specific companies, matching buyers with sellers and taking positions using their own money, as necessary, to smooth trading on the floor of the stock exchange.

Now, the old specialists have given way to designated market-makers. Knight is the number four designated market-maker on the NYSE and handles about 10% of NYSE transactions daily.

Getco is number two, transacting about 20% of NYSE volume, while potential suitor Virtu is number six. By acquiring Knight, Getco would be able to see more "flow" which gives it an advantage in both market-making operations and in high frequency trading.

Money Morning Capital Wave Strategist Shah Gilani explained, "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."

Gilani continues, "[Market-makers] 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…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."

Now consider what an advantage it would be for Getco to acquire Knight and increase its order flow by 50%, to keep 30% of the NYSE's daily volume in-house.

Designated market makers, such as Getco and Knight, are charged by the NYSE to "manage a physical auction to combine with an automated auction that includes algorithmic quotes from other DMMs [designated market makers] and market participants," according to the NYSE Euronext Website.

As designated market-makers, Getco and Knight must constantly maintain bid and asked quotes in their assigned shares. They also manage the intersection between high-frequency traders and the NYSE, including the old-fashioned floor traders.

If there is sudden volatility in one of their shares or even a market crash, designated market-makers are expected to constantly provide bids and offers under all circumstances.

Another Bonus to Buying Knight Capital

However, Knight has another role in the NYSE.

Knight Capital is the only NYSE Supplemental Liquidity Providing Firm (SLMM).

As an SLMM, Knight plays a different role.

The NYSE Euronext Website explains, "Supplemental Liquidity Providers (SLPs) are high-volume trading members who add liquidity to the NYSE. The SLP program rewards aggressive liquidity suppliers who complement and add competition to existing quote providers."

In other words, a supplemental liquidity provider acts like a market-maker for at least 10% of the trading day (that's 39 minutes, in case you were wondering).

The rest of the time, a supplemental liquidity provider is free to trade its own account and has no responsibility to post or honor bids and offers in its assigned shares. When the going gets tough, the supplemental liquidity provider can turn off its computers and call it a day-something a designated market-maker cannot do.

This is another reason for Getco to want control of Knight-to be a recognized high-frequency trader without the responsibilities that come with being a market-maker for 90% of the trading day anyway.

Allowing a single company to control 30% of NYSE order flow is probably not a great idea. Especially since another arm of that same company can use that flow to enhance high frequency trading for its own book.

Another notable feature of the firms interested in buying Knight Capital: They have private equity backers.

As Money Morning's Gilani noted, this should raise eyebrows at the U.S. Securities and Exchange Commission.

"Let's just see if the SEC is going to let a private HFT operation with private equity money and clout behind it buy Knight and turn what's left of the public's order flow into the private seeing-eye dog of one of the Street's big insider Dogs," said Gilani. "This is going to be interesting."

Knight Capital stock was down nearly 5% in trading Thursday morning.

For a closer look at Knight Capital, plus another Wall Street development that should be on your radar, check out Shah Gilani's latest Street analysis here.

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  1. alex | December 12, 2012

    at least now rogue traders and high frequency traders as well as flash crashes can be monitored in real time by anyone using software such as sceeto . Finally the ordinary small investor can have some idea whats going on.

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