Knight Capital heads into make-or-break weekend

Fri Aug 3, 2012 10:56pm EDT

A trader works at the Knight Capital kiosk on the floor of the New York Stock Exchange August 1, 2012. REUTERS/Brendan McDermid

A trader works at the Knight Capital kiosk on the floor of the New York Stock Exchange August 1, 2012.

Credit: Reuters/Brendan McDermid

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(Reuters) - Knight Capital Group Inc's future remained in flux as it headed into the weekend trying to clinch a rescue deal, but there was skepticism on Wall Street that one of the largest U.S. equities trading firms would find a suitor before Monday.

Knight was plunged into crisis on Wednesday when it lost $440 million, most of its capital, after a software glitch caused it to make thousands of unintended trades on about 140 stocks.

Knight said on Thursday it was actively pursuing strategic and financing alternatives.

Early on Friday unconfirmed reports that the company had received a line of credit led to a partial recovery in its stock price and helped persuade some major clients to resume trading with the firm.

At least one private equity firm, TA Associates, signed a non-disclosure agreement with the firm, a signal that it was looking at Knight's books for a potential acquisition or investment. TA Associates was not immediately available for comment. Knight did not respond to calls on Friday.

Sources familiar with the plans of some other private equity firms said they would be looking at Knight as well.

But sources at some other U.S. private equity firms that are active in the financial services sector said they had been approached by Knight's advisers Sandler O'Neill but decided not to pursue a deal with the firm.

"To go in fast and take a lot of risk - usually you do that when the terms and the price are safe," said a senior private equity executive whose firm was approached but decided not to pursue Knight.

One difficulty for bidders would be estimating the size of potential legal liability that the company could face in any shareholder lawsuits or enforcement action by regulators. With little time to investigate the reasons for the trading problems, it could be hard to assess the risks before making a deal.

A trader at Knight, asked if he knew who was responsible for the glitch, said: "Everyone was like, not to say pointing fingers at each other, but like 'Who's doing this?' kind of atmosphere. ‘It ain't me. I'm on the program desk. It's not me, I can assure you of that,'" the trader said.

The top U.S. securities regulator said government lawyers are trying to determine if Knight violated a new rule designed to protect the markets from rogue algorithmic computer trading programs.

The Securities and Exchange Commission's market access rule requires brokers to put in place risk control systems to prevent the execution of erroneous trades or orders that exceed pre-set credit or capital thresholds.

In particular, the SEC said it is looking at whether the software used by Knight was properly tested before it was put into use.

Shares of Knight, the nation's largest retail market maker of U.S. stocks, closed up 57 percent at $4.05 on Friday, still well below their $10.33 closing price on Tuesday, the day before the trading debacle occurred.

For a market already suspicious that the system might be fundamentally broken after 2010's "Flash Crash" and the botched Facebook IPO in May, the troubles at Knight have been another blow to investor confidence.

Other Wall Street banks and brokers are poring over their trading systems and rethinking the way they test software to make sure they don't become the next Knight.

Executives at the firms said it was a wake-up call that could prompt them to improve risk management controls. However, at a time when Wall Street is cutting costs, spending money on better systems to test software and manage risk could be an expensive proposition.

"We want to make sure that what happened to Knight doesn't happen to us," said the head of one investment bank.

In a letter to clients, Knight's futures division confirmed that customers' funds for commodity futures trading accounts "are segregated and kept separate from the funds of Knight" as required by regulators.

MOVING QUICKLY

Knight's predicament has become all-too familiar in recent years. During the financial crisis of 2008, several major financial services firms, including Bear Stearns and Lehman Brothers, fought for their survival over a weekend. Bear was rescued and Lehman went under by Monday morning.

More recently, MF Global frantically tried to find a white knight over a weekend and failed, filing for bankruptcy.

Knight faces some of the same challenges in finding a savior over a short period of time. Any buyer will need the ability to move quickly and put up enough capital to make sure that Knight remains a reliable counterparty to its trading partners, financial services bankers and private equity executives said.

A buyer would also have to get comfortable with Knight's financials, and perhaps more importantly its technology, and be sure that the glitch does not happen again, the bankers and executives said.

One private equity investor said he suspects that eventually Knight will get broken up. "Knight has many more businesses than just the equity market making business. Some are good and some are not," he said. "I'm not sure who would want them all."

The company was also in talks with potential buyers, including trading firm RJ O'Brien, to sell its futures brokerage unit, the New York Times reported on its website. RJ O'Brien declined to comment.

SOME RESPITE

Knight got some respite on Friday after the Wall Street Journal reported the company had told brokers it had obtained a line of credit. A line of credit could address concerns that have surfaced as to whether Knight has adequate capital to maintain its trading.

The company would not confirm that report, however. Sources at other firms said that they had heard that news only from reporters.

Then several major customers, including retail brokerages TD Ameritrade and Scottrade, said they had resumed routing trades to Knight, which in 2011 was the largest U.S. retail market maker.

"After considerable review and discussion, we are resuming our order routing relationship with Knight," TD Ameritrade said in a statement.

Earlier on Friday, mutual fund giant Vanguard Group said it was still not routing orders through Knight, and according to people familiar with the situation, Fidelity Investments' brokerage also was continuing to avoid routing customer orders to Knight. Knight's trading volumes remained below usual levels on Friday.

For example, through Tuesday of this year, Knight accounted for 20 percent of the market making activity in shares of Apple, one of the most actively traded stocks on a daily basis. By midday Friday, Knight was the market maker for just 2 percent of the share volume, according to data from Thomson Reuters Autex, though market makers may not be reporting all trade data.

"A lot of buyside firms have got us on hold for now," said one Knight trader, who did not give his name because he is not authorized to speak to the press.

Market makers such as Knight buy and sell shares for clients and provide liquidity to the equity market by stepping in to buy and sell to insure orderly, smooth activity. The trading snafus have revived questions about the integrity of the equity markets.

'QUIET' ATMOSPHERE AT KNIGHT

Outside Knight Capital's Jersey City offices, security warned reporters not to harass employees. Police officers were also present, and reporters were told to stay off the company's property.

One staffer, toting a set of golf clubs, said, "I don't want to care," when asked how things were going.

Another called the atmosphere at work "quiet, very quiet."

One trader said staff had received no announcements from management as yet but described the atmosphere as "definitely better than yesterday," with people trying to carry on as usual.

But he noted the company's future remained in doubt.

"I thought by this morning we might have heard something. I think a lot of this stuff might get done over the weekend, maybe Monday the latest," he said.

(Additional reporting by Jed Horowitz, Jessica Toonkel Rodrigo Campos, Angela Moon, John McCrank, Hilary Russ, Greg Roumeliotis and Suzanne Barlyn in New York, Ann Saphir in Chicago and Sarah Lynch in Washington; Writing by David Gaffen, Ben Berkowitz and Paritosh Bansal in New York; Editing by Edward Tobin, Lisa Von Ahn, Steve Orlofsky, Leslie Adler, Martin Howell and Carol Bishopric)

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