The Real Story Behind the Knight Capital Trading Fiasco

By: Money_Morning

Shah Gilani writes: Oh, you are going to love this.

That whole Knight Capital fiasco last Wednesday, when a software glitch caused them to flood the market with thousands of unintended orders, it ain't exactly what you think it is.

Sure, they tripped over themselves in the dark pool where they were trying to compete.

But somewhat interestingly (okay, a LOT interestingly), the competitor that drove them to "upgrade" their trading software, which malfunctioned and caused them to actually bid-up share prices erroneously and then buy them at inflated prices, was none other than, wait for it...

The New York Stock Exchange.

That's not the whole story, or even the good part. Oh, it gets better. A lot better

Knight claimed a $440 million trading loss on Wednesday resulted from their computer glitches and sunk the company (at least for now; I'll get to that).

Well, according to Nasdaq (this was on its site: nasdaq.com), it wasn't a trading loss at all. Knight paid Goldman Sachs a $440 million fee (commission?) to take the errant shares Knight had bought on Wednesday morning off its hands.

Now, I don't know what Goldman did with those shares, but my guess is they held most of them and sold them on Friday when the market soared a few hundred points. Of course, that's not a "prop" trade. Knight is a customer of Goldman's (it is now...).

But who cares?

Goldman Sachs ripped a customer for a $440 million fee, virtually bankrupting it in the process, flipped the shares it bought from Knight to "help" them (and first of all, probably overly hedged itself... as in enough to be net short... the large stake it holds in Knight's convertible preferred) for a tidy profit, and then probably shorted the stock (before "helping" them, and themselves to their little fee) before the stock collapsed, then probably gave it its "lifeline" (that's a guess, and I'm being sarcastic, but it's possible). And maybe we'll find out where that lifeline Knight got on Friday really came from) before buying a ton of Knight's shares back on Friday before hearing (of course... before) that several big firms were looking at buying Knight.

What's my point in the above LONG sentence? Who cares! That's all business as usual at the Golden Vampire Sachs.

That's after-the-fact stuff.

What's more interesting is why all this happened in the first place.

Here's what you probably don't know...

How Knight Capital Blew Itself Up
Back in July, the NYSE got permission (from the SEC... oh, those guys are good) for a one-year pilot program. The name of the program is... wait for it... the "Retail Liquidity Program."

Are you laughing? You will be.

The Retail Liquidity Program allows the NYSE to transact on the exchange (its Exchange), for the benefit of retail customers only, at better than posted prices.

That's right. If you're a retail investor and you buy or sell a stock on the NYSE, you might get a price better than the bid, if you're selling, and a price better then the offer, if you're buying.

Mind you, it's not much. Maybe one-tenth of a cent. But hey, you know, on your 100 share orders, that adds up to a lot of money. Maybe now you can afford that Rolls Royce.

You didn't know that, did you? And why should you? You wouldn't because YOU don't transact on the NYSE. YOU don't send your orders anywhere.

Here's what's happening behind the scenes...

When you place an order with, say, TD Ameritrade, or Scottrade, or Fidelity, or E*Trade (these are all customers of Knight Capital; I'm getting to that), they "route" your orders to be executed against bids and offers elsewhere. Those bids and offers may be on the NYSE, at some bank (maybe Goldman Sachs), on some market-maker's trading desk (like Knight Capital's desk... they're a market-maker, you know), or in some dark pool, or at some other hole in the system where trades slip into darkness.

Your broker routes your trade for execution to some destination, because he is paid to send it there. That's right; your broker is paid to send your order somewhere, and if it's an NYSE-listed stock, it probably won't even be sent to the NYSE.

That's because the NYSE doesn't pay for "order flow." Oh, wait a minute...

They do now.

Under their Retail Liquidity Program, they can now pay for order flow, kind of. They get orders directed to them by offering a slightly better price on an execution than is posted on their own Exchange.

The idea is that they can't compete with companies like Knight, who pay for order flow (so it never gets to the NYSE) and take the other side of trades or match them off against other order flow in their systems, or other people's systems.

I know this is a little confusing. But here's what you need to know.

This whole "paying for order flow" thing is about collecting as many orders as you can get under your roof. The more orders you see coming your way, the better you know what the bids and offers are out there, the better you can "predict" prices, and the more profitable your trading will be... that is... if you're high frequency trader, or a market-maker... like Knight.

So, the NYSE gets to compete with Knight. And Knight doesn't like that. So, it upgrades its software to jump the NYSE. And it blows up.

Knight's systems (probably "pinging" and looking to influence market prices and initiate trades) sends out orders (I'm speculating here), which end up lifting bids, which ends up triggering Knight to buy shares, which ends up being a huge cluster you-know-what, because it's all a mistake, you know. Which means they own a bunch of stocks they don't have enough capital to hold. Which means Goldman Sachs gets to bend another customer over.

Which means everything is normal on the Street.

You just can't make this stuff up.

Source :http://moneymorning.com/2012/08/07/the-real-story-behind-the-knight-capital-trading-fiasco/

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