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The Markets Are Totally Fine. Really.

07

August, 2012

 

“There’s no reason to become alarmed, and we hope you’ll enjoy the rest of your flight. By the way, is there anyone on board who knows how to fly a plane?”

We are very pleased Knight lives on, although we empathize with the heavy loss of wealth felt by KCG employees and shareholders. However, contrary to what many have said yesterday – that Knight alone was affected and that they alone paid the price, we just must weigh in and disagree.

Knight Capital is very ingrained in the structure of our modern stock market. Consider the following large ways in which they interact with the marketplace:

1)      They are a “market maker”, and one of only four DMM’s on the floor of the NYSE. They are also responsible for major trading on all of the other exchange families – NASDAQ, Direct Edge, and BATS.

2)      They own stakes in major stock exchanges.

3)      They run major dark pools.

4)      They are lead market maker and authorized participant for many ETFs.

5)      They are a major wholesaler that buys order flow from many brokerage firms, and trades against that order flow for profit, using advanced modeling techniques.

 

Speed / automated high frequency trading techniques and strategies are built into all of those interactions. And Knight is both partner and competitor to other brokerage firms, independent HFT firms, as well as stock exchanges. And so, when they stumble, it absolutely affects others. To say that nobody took the hit for Knight’s rogue algo, except Knight alone, is just not true.

 

If you were trading any stock, and certainly one of the affected 148 stocks, in those 45 minutes on Wednesday August 1st, you were affected. Correlations being what they are in our heavily indexed and automated markets, all stocks exhibited some price dislocation. Certainly those 148 highlighted stocks displayed massive price dislocation. You paid or sold at prices that deviated from intrinsic and efficient values – which efficient markets are supposed to track.

 

If you traded with stop loss orders, and your stops were triggered, you were stopped out of a trade due to a plumbing glitch in the market, and not because of anything to do with your investing/trading thesis.

 

If you traded ETFs on August 1st or August 2nd, spreads widened considerably, especially in the more illiquid ETFs. Read this article: Knight’s Troubles = ETF Trading Woes.

 

If you are an investor on the sidelines, with perhaps some money in the market through a manager or market professional, you witness these frequent technology events and you lose confidence. Maybe you even take some money out of equities, or maybe you decide not to commit any new monies. How many billions have come out of the markets since the Flash Crash in an up-trending market?

 

If you work on Wall Street, or perhaps have worked on Wall Street but were downsized, you know full well how these events affect you. When investors flee the markets, the watering hole quenches fewer thirsts.

 

We all want Knight to succeed and do well. And we all want the stock market to be a place where investors feel safe and confident, so that we can all do well. Events like the Flash Crash, the botched Facebook and BATS IPOs, and the Knight algo glitch without question affect the marketplace for all investors. These events are occurring with increasing frequency. Did you know that even yesterday, a day characterized by low stress and volume, technical glitches stopped trading in Spain and Tokyo?

 

The solution is not to keep quiet and pretend that the emperor is wearing a marvelous technicolor tunic; we must speak up and fix the leaks in the dam before that dam comes crumbling down, and not after. Our regulators need to act now. What we all need is the fixing of the market’s foundation, as we alluded to in yesterday’s note, and not more neglect and “hope for the best.”

 

 

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