Counterparties: A high-frequency Knightmare

By Ben Walsh
August 2, 2012

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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

Remuneration
“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

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

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

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

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

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

3 comments

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** pleads ‘guilty’ to the charge of – aggravated Schadenfreude **

First Macris and The Whale ‘do in’ the grand ambitions of the smartest guy in the room – any room – now the algols ‘do in’ KC. Call me cruel if it makes you feel good, but seeing these parasites who were running schemes that have no social utility whatsoever get hung by their own ropes – WTF is bad about that?

Posted by MrRFox | Report as abusive

The “Takedowns” link to Ryan Louis Cooper’s article is broken, and now just goes to a GoDaddy ad. Maybe someone forgot to pay the bills?

Posted by Windchasers | Report as abusive

The Ryan Louis Cooper article can be found here: http://www.ryanlouiscooper.com/2012/08/w hy-are-small-countries-better-at.html

Posted by jyaroch | Report as abusive