Knight Has ‘All Hands on Deck’ to Deal With $440 Million Bug

Whitney Kisling, ©2012 Bloomberg News

Published 01:28 p.m., Thursday, August 2, 2012

(Updates throughout with more details, comments.)

Aug. 2 (Bloomberg) -- Knight Capital Group Inc. has "all hands on deck" and is in close contact with creditors, clients and counterparties as it tries to weather trading errors that cost it $440 million, Chief Executive Officer Thomas Joyce said.

Joyce said it's "hard to comment" on discussions with creditors as Knight stock extended a two-day plunge to 77 percent and the firm explored strategic and financial alternatives following a loss almost four times its annual profit. The problems were triggered by what Joyce called "a large bug" in software as the company, one of the largest U.S. market makers, prepared to trade with a New York Stock Exchange program catering to individual investors. Some clients refrained from doing business with the firm today.

"Technology breaks," Joyce said in an interview from Jersey City, New Jersey-based Knight on Bloomberg Television's "Market Makers" program with Erik Schatzker and Stephanie Ruhle today. "It ain't good. We don't look forward to it."

Knight was fighting to preserve its business as concern grew about its solvency and pressure built for it to find a buyer or investor. Analysts at CLSA Credit Agricole Securities said bankruptcy was a possibility if it failed to get financing. The trading problem caused dozens of stocks to swing as much as 151 percent and left the firm with what Joyce called a "large error position."

Knight said its broker/dealer subsidiaries are in compliance with capital requirements. The company is in contact with clients, counterparties and creditors as it works to recover, Joyce said.

‘Capable People'

"We're talking to a lot of capable people, people who are in touch with situations like this," Joyce told Bloomberg TV. "You might imagine during the day-to-day activity, it's kind of hard to comment" on discussions about possible credit lines.

Knight's shares plunged 60 percent to $2.75 at 3:06 p.m. New York time, after dropping 33 percent yesterday. Today's price is the lowest since the initial offering in 1998 and compares with its peak of $78.47 the next year, data compiled by Bloomberg show.

About 124 million shares of Knight changed hands today, making it the most-actively traded stock on U.S. exchanges, according to data compiled by Bloomberg of companies with a market value of at least $50 million.

The programming bug swept through the market at the open of exchanges on a day when Joyce, a 57-year-old Harvard College graduate known as TJ, limped into work following knee surgery. Joyce said that while the bug sent "a ton of orders, all erroneous" into the market as the firm prepared to trade with the NYSE's new so-called retail liquidity program, it had "nothing to do" with the NYSE.

Routing Elsewhere

The bad software code is gone now, he said, and some clients of the market-making business were executing with the firm by the end of yesterday after Knight told them initially to go elsewhere.

Citigroup Inc., the third-largest U.S. bank, is temporarily refraining from routing some trades through Knight, according to a person with direct knowledge of the matter. TD Ameritrade Holding Corp. has not yet started routing to Knight again, spokeswoman Kim Hillyer said.

"We are testing," she said in a phone interview. "We want to make sure the client experience remains good."

Knight spokeswoman Kara Fitzsimmons said she did not have "any confirmation or comment" about other clients still sending trades elsewhere. Stephen Austin, a spokesman at Fidelity Investmentsin Boston, declined to comment.

The NYSE reviewed trading in 140 stocks from Molycorp Inc. to AT&T Inc. yesterday as the market's open was disrupted. Trades that occurred during the height of the volatility were canceled in six securities, where prices swung at least 30 percent in the first 45 minutes. Trades in all of the other stocks were allowed to stand.

Error ‘Drumbeat'

The software malfunction was the latest black eye for the computer infrastructure of an equity market stilled haunted by the May 2010 market crash, the botched initial public offering of FacebookInc. and failed IPO of Bats Global Markets Inc.

Democratic U.S. Representative Maxine Waters of California said in an e-mailed statement that she is seeking hearings on the matter as a "drumbeat" of errors in stock markets shows the need for stronger controls.

Yesterday's problem shows regulation is "broken" and a study group should be convened to review technology and market structure, Arthur Levitt, former chairman of the Securities and Exchange Commission, said in an interview. Regulators would have been able to stop incidents such as yesterday's breakdown if they didn't face a lack of resources, he said.

Regulator Scrutiny

"The ability of regulators to do their job has never been weaker than it is today because of the failure of the oversight process," Levitt, 81, said today in an interview. Levitt serves as a consultant toGetco LLC and Goldman Sachs Group Inc. and is a director of Bloomberg LP, parent of Bloomberg News. "Congress has a greater responsibility for what we're seeing today than any regulator or any particular part of the industry. They've allowed this to happen."

Kevin Callahan, a spokesman with the SEC, said in an e-mail that regulators are "closely monitoring the situation and in continuous contact with the NYSE and other market participants."

Knight's market-making unit executed a daily average of $19.5 billion worth of equities in June, according to its website. The unit traded 711 million exchange-listed shares a day in June, or about 10 percent of the U.S. market, according to data compiled by the company and Bloomberg.

‘Most Susceptible'

"Market makers are the most susceptible to these types of problems, both as initiators of the problems and as victims of the problems," Bernard Donefer, a professor of information systems in financial markets at Baruch College, part of the City University of New York, and New York University's Stern School of Business, said in a phone interview. "The problem you have is contagion. A problem in one place and one time can cascade across asset classes and market makers. The contagion scares me most of all."

Knight's $440 million loss compares with net income of $115.2 million in 2011 and is more than the company's market value of $272 million today, data compiled by Bloomberg show. The company was worth as much as $4.8 billion in 2000 and valued at more than $1 billion before yesterday, according to data compiled by Bloomberg.

Capital Base

"Although the company's capital base has been severely impacted, the company's broker/dealer subsidiaries are in full compliance with their net capital requirements," Knight said today. "The company is actively pursuing its strategic and financing alternatives to strengthen its capital base."

The loss represents about 40 percent of Knight's book value and would "exhaust" the firm's cash, according to CLSA Credit Agricole Securities, which said Knight should consider selling itself.

"We believe Knight Capital is at risk of bankruptcy following the loss and so we are lowering our rating to sell," Robert Rutschow, a New York-based analyst with CLSA who had an outperform rating on the stock, wrote in a note today. He also cut the price estimate to $3 from $9. "The company's best option at this point is a sale."

Knight's $375 million of 3.5 percent convertible bonds fell 10.125 cents to 73 cents on the dollar, according to Trace, the bond-pricing reporting system of the Financial Industry Regulatory Authority. The yield increased to 16.7 percent.

While Knight reported July 18 that second-quarter earnings exceeded analyst projections, sales fell short by 1.7 percent. Cash and equivalents fell 22 percent to $364.8 million in the last quarter, data compiled by Bloomberg show.

1995 Founding

"This loss is larger than we expected," Rich Repetto, a New York-based analyst with Sandler O'Neill & Partners LP, wrote in an e-mail. "More monitoring and safeguards need to be built into these trading algorithms of both market makers and exchanges."

Knight has been at the center of U.S. equities trading for more than a decade. It was founded in 1995 and grew during the bull market of the late 1990s into one of the biggest traders of the technology stocks that led the market's surge and subsequent plunge. It had 1,423 employees at the end of 2011, according to a regulatory filing. Knight grew through more than 15 mergers and acquisitions since 2000, according to data compiled by Bloomberg.

Joyce became CEO and president in 2002 after serving for five months as head of global trading for the institutional brokerage business at Sanford C. Bernstein & Co. He spent 14 years at Merrill Lynch & Co. overseeing electronic trading and worked on the acquisition of Knight rival market-maker Herzog, Heine & Geduld Inc. in 2000.

Sharpening Pencils

Speculation swirled through the market about what options Knight may be considering as it reviews its options. Joyce declined to comment during today's interview on the nature or existence of specific conversations with private-equity firms.

The company is in discussions about a potential merger or capital investment with trading firm Virtu Financial LLC, the Wall Street Journal reported, citing unnamed people familiar with the matter.

"The first thing I did in the morning is to have an analyst take a look at Knight to see whether it's a company we'd like to own a piece of," Thomas Caldwell, who oversees about $1 billion as chairman and chief executive officer of Toronto-based Caldwell Securities, said in a phone interview. "I'm sure some people are sharpening their pencils to see whether this is something that they want to continue or it's something that can break again and again."

--With assistance from Michael J. Moore, Nina Mehta and Lu Wang in New York and Ryan Kerr in Washington. Editors: Michael P. Regan, Lynn Thomasson

To contact the reporter on this story: Whitney Kisling in New York at wkisling@bloomberg.net

To contact the editor responsible for this story: Lynn Thomasson at lthomasson@bloomberg.net