Counterparties: A high-frequency Knightmare

August 2, 2012

Welcome to the Counterparties email. The sign-up page is here, it’s just a matter of checking a box if you’re already registered on the Reuters website. Send suggestions, story tips and complaints to

When your business model is to execute trades profitably, it’s pretty hard to destroy your franchise more effectively than contriving to lose $10 million a minute trying to do just that on the New York Stock Exchange. That’s how much Knight Capital lost yesterday morning when its electronic trading algorithms malfunctioned, causing “the firm’s computers to rapidly buy and sell millions of shares in over a hundred stocks for about 45 minutes after the markets opened”.

The damage in total: about $440 million. That’s more than the $289 million in revenue the company earned last quarter; it’s four times its annual profit. That’s 40% of tangible book value. How bad is that? With its shares down 63% on the day, and more than 75% since the error, Knight is now trading at valuations similar to Morgan Stanley, Citigroup and Bank of America. It’s now exploring that most ominous of financial euphemisms, “strategic alternatives“.

This is a really bad time to do such exploring, and not just because of Knight’s self-immolating tendencies, the WSJ reports:

Stock volumes are at a five-year low and volatility seemingly does nothing to bring trading activity back… There are a range of competitors in the wings trying to attack Knight’s core business, trading with the retail brokers. Goldman Sachs, Cantor Fitzgerald and the hedge fund firm Two Sigma have been gearing up in the business.

It’s also far from reassuring to hear these kinds of comments from the CEO of what is at heart a technology company: “Technology breaks. It ain’t good. We don’t look forward to it”.

That capacity to break may be more a feature of electronic trading programs than a bug. As Felix noted, “weird things happen when you get deep into the weeds of high-frequency trading, a highly-complex system which breaks in entirely unpredictable ways”.

Still, there is one likely cause for what happened. When you zoom in and look at the trades at intervals of less than a second, it starts to look like a new NYSE trading system may have been involved. Stephen Gandel has an explanation of the NYSE’s “Retail Liquidity Program”, which launched Wednesday and which uses “algorithms to figure out when it makes sense to offer a slightly better price than what others are offering, and snatch up stock trades, this time away from Knight and others”.

If the RLP is what caused Knight’s losses, the NYSE may have fatally wounded both a competitor and its own reputation. The whole episode is far more intriguing than a good old-fashioned busted Internet IPO. – Ben Walsh

On to today’s links:

EU Mess
Draghi’s choice to “play mind games with financial markets … marks a new low for European crisis management” – Tim Duy
Draghi downgrades the ECB’s commitment to do “whatever it takes” to save the euro to “guidance” – NYT

What Could Go Wrong
Prescription drugs’ newest ingredient: gamification – PSFK

Advanced Strategy
Google Wallet to become more like a real wallet and allow multiple cards – WSJ

Good Questions
“What’s a guy gotta do around here to lose a little credibility?” – Jesse Eisinger

“Central bankers just destroyed Wall Street’s 2012 bonus season” – DealBook

Regulatory Inertia
Trends in financial regulation delay tactics: overly exhaustive cost-benefit analysis – Bloomberg

“It’s as if we put Richard Feynman in charge of NASA, and he started talking about creationism and homeopathy” – Ryan Louis Cooper

Why the Japanese love the fax machine: an aging population that values handwriting – BBC

Seven predictions based on the economics of Olympic success, including “Bob Costas will make you cry” – Grantland

Jared Kushner’s internal memo announcing the departure of Elizabeth Spiers from the New York Observer – Nick Rizzo

Goldman invests in NYC jail program, but in a good way – NYT


Comments are closed.