Is Knight Capital’s Loss Investors’ Gain?

By Jay Wei - August 8, 2012 | Tickers: GS, KCG, BX | 0 Comments

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Hoping your market maker loses money would be like not wishing a stock exchange to perform well as an investor. Market makers stand to serve investors by providing low-cost market trading liquidity. In other words, investors rely on well-functioning market makers to ensure their fair trades. While some investors may have gained on the day Knight Capital (NYSE: KCG) lost $440 million from its erroneous bid-ask positions, the company’s loss could mean wider bid-ask spreads in the future for investors whose brokers use Knight Capital to route orders. To settle trades, market makers like Knight Capital that handle substantial securities transactions must employ large amounts of operational capital. Knight's one-day loss of this magnitude presents an immediate challenge to its capital funding. A capital shortage could well affect Knight’s market making ability, leading to lower transaction volume and increased transaction costs for investors.

A market maker’s operations normally are a rather steady and safe business, even within the often volatile stock market environment. Market makers are supposed to profit in both up and down market conditions because of their ability to bid low and offer high with their broker clients. Such a positive bid-ask spread means that a market maker can buy at a lower price and turn around to sell at a higher price. The spread often is narrow to facilitate trading liquidity, and the resulting profit margin is thin. But many expect the market making business to be a reliable source of continued earnings accumulation, rather than a means for large scale growth. However, things could go wrong even for the seemingly routine and reoccurring market making activities. Without close monitoring and on-target execution of the bidding-and-offering process, a market maker could end up with a mismatch between its bid and offer positions, meaning a negative bid-ask spread, and would have to settle for a loss.

Such a reversal in the bid-ask spread is what actually prompted the transaction loss at Knight Capital. The company’s computer program used to handle its market making activities entered into some erroneous positions due to a software bug. The market making fault caused wide swings in many stocks, and some transactions with the most price volatilities were later canceled by the NYSE. But Knight Capital was in the end left holding a large error position for a settlement loss, amounting to almost four times its net income from last year. While the incident is unfortunate for the company and its shareholders, it is also alarming for investors in general. The malfunction of Knight’s quotation scheme may affect people’s confidence in the integrity of the market trading systems. Had the computer error caused Knight’s bidding and offering to move in the opposite direction, investors would have been the ones to lose.

Now with Knight Capital being the losing party, what may the future hold for the company and its shareholders? Rumors of the company’s potentially going bankrupt have been circulating. After all, the $440 million loss is almost one-third of Knight Capital’s equity book value of $1.497 billion at the end of its most recent quarter. The key to the company’s survival may hinge on its ability to obtain cash through immediate capital infusion. Without sufficient cash on hand, a market maker won’t be able to quote and settle trades at its usual level of transaction volume. Knight Capital has first arranged for Goldman Sachs (NYSE: GS), a market maker itself, to buyout some of its error trading positions to cut losses and preserve some cash. The company has also struck a capital investment deal with various investors, including Blackstone (NYSE: BX), an expert in equity investment. Equipped with the necessary cash capital, Knight should now be able to get back to its normal course of business. It was an operational mistake that the company couldn’t afford to have.

Knight stock was trading in the range of 60 percent of its book value before the loss. The stock then dropped to reflect the loss deduction from the book value but in a rate that initially maintained the earlier trading discount. The stock further declined later to trade in the range of 30 percent of the lowered book value. Factoring in both the trading loss and the equity-dilution effect from the capital infusion, which calls for the issuance of 267 million shares at $1.50 per share to participating investors, Knight now has a book value of about $4 per share, calculated as: ($1,497 million - $440 million + $1.50/share x 267 million shares)/(98+267) million shares (the company has 98 millions shares outstanding before the new issuance). This compares to the respective book value of about $15 and $10 before and immediately after the loss. To trade in the original 60 percent discount range, Knight stock would have to be further down to around $2.5 from its current $3 level, which now gives the stock a discount of 80 percent of its adjusted book value, unlikely to be endorsed by potential investors at present time.

Expect a long road to recovery for Knight Capital, especially considering that earnings in the market making business are mostly about the gradual accumulation of the narrow market making spreads. Barring any other operation mishaps, it may take four to five years for the company to get back to where it was before the loss incident.

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