the Knight Capital Group (KCG) end game: effective change of control

a recap

Last Wednesday morning, KCG started up a new software trading link, whose total purpose still isn’t clear, to the NYSE computers.

The new software went berserk, buying everything in sight–and without regard to price–as soon as it was turned on.  As subsequent media comment has made apparent, stuff like this happens every so often in today’s financial world.  Usually, though, the defective program is shut down within a minute or two.  Not so in the KCG case.  It took–for reasons also not clear–the better part of an hour for KCG to pull the plug.

The company subsequently announced it had lost $440 million due to the malfunction.

big problems

KCG faced a number of related problems because of this.  Specifically,

1.  If the average loss was 10% of the purchase price, KCG had bought $4.4 billion worth of stock that it would have to pay for three days later.   If the loss was 5%, KCG would have to come up with $8.8 billion.  In any event, KCG only had about $400 million in cash on hand.

2.  The software glitch was like a gigantic fireworks display.  Every trader on Wall Street knew KCG was in trouble–and might have difficulty settling (i.e., paying for) the trades it had made.  So selling out of the positions it had accidentally accumulated, without offering substantial discounts, would have been very difficult.  In some cases (see my previous post on KCG), KCG held far too much to be sold quickly.

KCG appealed to the NYSE to cancel the accidental trades, but was mostly refused.  After a similar incident last year, Wall Street drew up a set of rules for when such trades might be broken.  Only six of the 150-odd stocks Knight bought qualified.

KCG solved this issue–apparently on Wednesday–by selling the bulk of the erroneous position to Goldman.

3.  As a market maker, KCG makes money by collecting a fee for matching buyers and sellers of stock.  It’s a little like a bank.  Customers only deal with it if they believe it is financially sound.  And, regulators require that it put aside a little capital to back each trade it brokers during the three-day settlement period.  But the rogue software program had tied up all of KCG’s capital. The loss it generated had also wiped out all its cash.

So KCG couldn’t accept any new trading orders.  And long-time customers wouldn’t place any, for fear of potential problems (too geeky a topic, even for PSI) if KCG went out of business before trades could settle.

the solution

One part was the sale of stock to Goldman, which got KCG out from under the need to come up with the money to pay for the erroneous trades.

The second, reported in an 8-K filing with the SEC on Monday, is the sale of $400 million in convertible preferred stock in KCG to a group of the company’s long-time business partners.

There are two classes of convertible, one with limited voting rights.  Both earn interest at a 2% annual rate.  Each $1000 preferred can be exchanged for 666.667 shares of common, meaning an effective purchase price of $1.50 per KCG share.

According to the 8-K, conversion would leave the preferred holders owning 73% of KCG.

tidying up may still need to be done

The complicated structure of the preferred issue–two classes, each with different voting rights–seems to me to imply that some of KCG’s rescuers aren’t allowed to own a market maker, either because of conflict of interest considerations or market share concerns.

change of ownership has happened, though

…although in a deferred way (which, of course, is what convertibles are all about).  The directors of KCG have agreed to turn over almost three-quarters of the company to their rescuers in exchange for the bailout.

an attractive stock?

I’m not an expert at financials, so I don’t have a professional opinion.

The one think that strikes me is that, pre-crisis, the stock was trading at about $10 a share (down from the 52-week high of $14+ achieved last October).  If we assume that the $400 million injection from the preferreds offsets exactly the loss from the renegade trading software, then the only factor that’s really changed over the past week is that there are 4x as many shares outstanding.  That would imply the equivalent share price today would be $2.50.  But the stock is currently trading at well over $3.   Strange.   Very strange.

Knight Capital and its algorithmic trading snafu

Knight Capital

Though not particularly well known to individual–and even some professional–investors, Knight Capital is a very large market-making and trading broker in the US equity market.

algorithmic trading

Algorithmic traders, or “algos,” are typically IT-savvy arbitrageurs.  Like any other arb firms, their business is finding and exploiting differences in the pricing of identical, or very similar, instruments.  Algos differ from traditional arbitrageurs in that they use computer programs to do their searching for them.  That way they can cover more ground than humans, potentially trading more quickly and spotting more opportunities. Computers also execute their trades.

On Wednesday morning, Knight Capital was running for the first time an algorithmic trading program it had apparently developed itself.  The story isn’t 100% clear, but it sounds to me as if Knight was hoping to create an algo service that could be used by individual investors.  In any event, Knight’s computers started churning out buy orders for about 150 stocks at the opening bell.  But the quantities being asked for were huge–much larger than Knight had intended.  And some of the stocks in the bundle were, well, weird.

One of the more offbeat selections was Wizzard Software (WSE).

The issue had closed on July 31st at a stock price of $3,50, on volume of 15,067 shares.  Wizzard provides home health care staff in the West, resells podcasting services from ATT and Verizon, and, yes, it apparently also develops corporate software.  In 2011 WZE had total revenue of about $6.5 million, and lost money.

From the chart I looked at, Knight’s initial order for WZE seems to have been for an astoundingly large 150,000 shares.  That’s a bit less than 2% of the company.  It’s also at least two weeks’ total trading volume. (My guess is that it would take several months to accumulate that amount, if you wanted to do so without moving the price much.  And then, of course, absent a sharp reversal of WZE’s fortunes, you’d have much greater difficulty getting back out.)

It reportedly took Knight almost an hour to figure out that something had gone wrong with its software.  Rival market makers were much quicker off the mark and were providing boatloads of stock to Knight at ever-rising prices.  When the music finally stopped, WZE was close to $12.  WZE was one of six stocks where erroneous trades were cancelled b market officials.

But that left around 146 issues where the Knight orders weren’t simply torn up.  The firm accidentally owned massive (for it) amounts of t=stock it didn’t want.  Once it realized what was going on, Knight cancelled any remaining buy orders and began dumping out the stock it had just acquired.  The company estimates it lost $440 million Wednesday because of the software glitch!!! (To be clear, I think Knight made the correct decision in selling immediately.  The gaffe was too big and too public for it to hope it might trade out of its positions slowly and quietly.)

press comment misguided

Most of the press stories about this incident have revolved around the idea that computerized trading is undermining the confidence of traditional long-only investors, especially individuals, in the integrity of the stock market and the desirability of holding equities for the long term.  I think the stories are  crazy.

For one thing, the S&P 500 only rose about five points in early trading on Wednesday–and then went sideways for most of the day.  If you weren’t a day trader, it may well be that the first you heard of the Knight Capital fiasco was on the news Wednesday night.  Or it might have been the paper on Thursday morning.

The real story?

Consider what has happened to Knight because of its foray into algo trading.

–Its stock has lost about three-quarters of its market value in just the past two trading days.

–The Financial Times reports that major clients have shifted orders to other market makers–Vanguard, e-Trade and TD Ameritrade among them.  Brokers did this initially at Knight’s request.  Clients are remaining mum for now.  Certainly, no one I’m aware of is saying the crisis is over and they’ve gone back to business-as-usual with Knight.  The silence on this score suggests clients think Knight may be badly enough wounded that counterparty risk is a concern.

–According to the FT, Knight has hired an investment banker to help it consider its options, including a merger or sale of the firm.

In other words, it’s conceivable that the management that built the company may soon no longer be in control of it.

I can’t imagine this snafu makes anyone more eager to get involved in algorithmic trading.  Quite the opposite.  The Knight experience may become the cautionary tale that prevents the spread of algo trading away from specialists and into the mainstream of equity trading.