December 19, 2012 at 15:51 PM EST
Knight Capital Group Deal Includes Huge Conflict of Interest
Chicago-based market maker and high-frequency trader Getco Holding Co. LLC sweetened its bid for distressed market maker Knight Capital Group Inc. (NYSE: KCG ) today (Wednesday), winning a takeover battle with rival Virtu Financial Holdings LLC. According to CNNMoney , Getco will pay to third-party shareholders either $3.75 per share in cash or one share of common stock in a new holding company that will be the actual acquirer of Knight. (Getco already owns a 23.8% stake in Knight). Cash payments to large, institutional shareholders, such as Jefferies, which is handling the financing of the $1.4 billion deal, will be restricted. In return, according to The New York Times , Getco will receive 233 million shares in the new holding company and 57 million Knight shares will be retired. Getco is the second-largest designated market maker on the New York Stock Exchange, transacting about 20% of the average daily volume traded. Knight Capital is the third-largest designated market maker, accounting for about 10% of average daily volume. By acquiring Knight Capital Group, Getco will still be the second-largest designated market maker, but with 30% of average daily volume going through the door, it'll be more on a par with No. 1 market maker Barclays PLC (NYSE: BCS ). That means Getco now has an unfair advantage in the markets. Here's why. To continue reading, please click here...
Chicago-based market maker and high-frequency trader Getco Holding Co. LLC sweetened its bid for distressed market maker Knight Capital Group Inc. (NYSE: KCG) today (Wednesday), winning a takeover battle with rival Virtu Financial Holdings LLC.

According to CNNMoney, Getco will pay to third-party shareholders either $3.75 per share in cash or one share of common stock in a new holding company that will be the actual acquirer of Knight. (Getco already owns a 23.8% stake in Knight).

Cash payments to large, institutional shareholders, such as Jefferies, which is handling the financing of the $1.4 billion deal, will be restricted.

In return, according to The New York Times, Getco will receive 233 million shares in the new holding company and 57 million Knight shares will be retired.

Getco is the second-largest designated market maker on the New York Stock Exchange, transacting about 20% of the average daily volume traded. Knight Capital is the third-largest designated market maker, accounting for about 10% of average daily volume.

By acquiring Knight Capital Group, Getco will still be the second-largest designated market maker, but with 30% of average daily volume going through the door, it'll be more on a par with No. 1 market maker Barclays PLC (NYSE: BCS).

That means Getco now has an unfair advantage in the markets. Here's why.

Knight Capital Group Deal: Conflict of Interest Increasing order flow is vitally important to market makers and to high-frequency traders. Getco is both.

Unfortunately for the markets, there is an inherent conflict of interest between market makers and high-frequency traders.

Let's look at the New York Stock Exchange definition of a designated market maker (DMM):

"The Designated Market Maker (DMM) is at the center of the NYSE market and is the only participant to have true obligations for maintaining a fair and orderly market for assigned securities. DMMs must quote at the NBBO [national best bid and offer] a specified percentage of the time. They must facilitate price discovery during market openings, closings and during periods of substantial trading imbalances and high volatility."

Designated market makers must be the best bid and best offer in their shares a certain percentage of the time and must use their capital to provide liquidity when there are peaks of volume or volatility.

Now consider what high-frequency traders (HFTs) do.

Money Morning Capital Wave Strategist Shah Gilani has explained, "High-frequency traders employ pattern-recognition algorithms that look deeply at bids and offers on stocks to determine if the movement on the bid quotes or offered quotes implies a directional tendency.

"Computer-driven algorithms are "reading' the quotes, the intentions of buyers and sellers as they put down their orders in real-time, to make a trade that the HFT player expects to profit from if the directional bias their computers pick up is correct," Gilani continued.

HFTs are constantly sending out orders to buy and sell shares that they have no intention of completing. This "pinging" of the market is really an attempt at influencing the directional bias of a specific stock to create an opportunity to make a profit.

"HFT players are constantly pinging stocks where their quotes are housed and displayed," Gilani said. "They send out their orders to manipulate others to adjust their quotes, which get fed into the HFT algorithms to determine any directionality; then, if an opportunity exists, the HFT computers buy or sell shares that someone else has put onto the market."

Now here is where the real conflict of interest occurs.

"They aren't quoting constantly as bona fide "market-makers' are supposed to do," Gilani wrote. "They are simply putting out millions of fake bids and offers which they pull almost immediately, just to read the movement of other market participants who react to the HFT come-ons."

Why You Get a Bad Deal Now that Getco has gotten Knight, they have access to 30% of the average daily volume on the NYSE from all sources.

This additional flow gives them more information about the true intentions of other market participants, creating new money-making opportunities for the in-house HFTs. That gives Getco an edge in the market and makes the market a lot less fair for the rest of us.

Of course, Getco's market-making arm is not supposed to give a "look" to Getco's HFT arm. Both are supposed to compete on an equal basis with other market participants.

But it is hard to escape the appearance of conflict of interest when HFTs account for so much of the market's average daily volume and when Getco can capture 30% of the market's average daily volume in-house.

When you add in the speed at which most trading takes place today - milliseconds or less - it further undermines the rationale behind the role of equity markets in a capitalist society.

Gilani continues, "What's undermining investor confidence in stocks is that it's all about speed and what Wall Street gets from having the advantage, and what games Wall Street erected to make money from the speed circuit that drives trading.

"It's about trading, not investing," Gilani concluded. "It's all about punching out what incremental gains you can in the short term, not about going the distance with safe investments in the long term."

Knight Capital Group was trading up nearly 6% to $3.53 in afternoon trading Wednesday.

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