Knight Capital and Intermediate Brokers

A share of stock is the simplest security known to finance. It is completely fungible and all shares of the same company are identical.

So shares should be very easy to trade. A seller offers 100 shares to a buyer, they agree a price, and exchange. Nothing could be simpler. Such deals could be done on the pavement, and before the era of stock exchanges they were.

Once stock exchanges were invented, they offered share buyers and sellers a venue for trading. Offers to sell and asking prices could now be put up on a board or screen at a central place, where they could be seen by buyers. The parties then made their deal based on this data.

Soon it was thought that instead of buyers and sellers dealing direct, they should be helped by brokers. So buyers and sellers hired brokers.

Then something really strange happened. The brokers began to feel that they could not do the broking themselves, and that they needed to instruct other brokers. Now these brokers' brokers, including Knight Capital, began to make the trades between buyers and sellers. The brokers' brokers worked behind the scenes, their role being unknown to most buyers and sellers. And from this concealed position, they were able to generate vast profits, all paid for by the buyers and sellers and their principals without their realising it.

What does Knight claim to do? Its website says it does market making and execution, and that it that provides its clients with "market access, speed and trading efficiencies".

This is puzzling. Why should holders of shares that are already actively traded - as the shares affected by Knight's software glitch were - need market making? Why would buyers and sellers who were already paying their own brokers need to buy market access through Knight, access into the most open markets in the financial world? Why would buyers and sellers need speed - would it matter to a pension fund administrator whether the fundís shares were sold in a nanosecond or an hour? How could a complex and costly multitier system of brokers create efficiencies?

The answers to these questions seem to lie in payments that Knight made to brokers to buy their customersí trades.

But now a glitch has occurred. Knight developed a software problem that caused some losses. All eyes focused on the IT issue, but the real problem for Knight was that the mask had slipped. The market suddenly began to doubt whether Knight's services were really needed. Customers bolted for the exits, and investors and lenders hesitated to come forward to bid for the company or lend money to it, to help it out of its troubles, except on the most stringent terms. Belief in its business model had drained away.

Was the market right to take this view? Could the market have missed something that might show it to be wrong about Knight? Does Knight have some unique and valuable assets or skills that would confound the marketís assessment?

Press reports have said that Knight has "physical data linkages" to 800 brokers, and that it would be very expensive to replicate so many physical connections. What, it might be asked, could these physical connections be? A network of tunnels under Manhattan connecting Knight with its customers, a flock of specially trained carrier pigeons, a team of road runners bearing order books? More likely that these connections are nothing more than a telephone line or a digital cable.

Whether Knight will make it through its current problems is unknown. But what is known is that the market has reevaluated Knightís role in share trading. That should mean cheaper trades for many market participants.

Published 7 August 2012.