Knight Capital Group Inc.'s (KCG) main business of making markets for retail stock trades is hugely prized on Wall Street, and now potentially up for grabs for a handful of competitors after a trading snafu steered big clients away from Knight.
The business, called wholesale market making, is dominated by Knight as well as Citadel LLC, UBS AG (UBS), Citigroup Inc. (C), and a division of E*Trade Financial Corp. (ETFC). Goldman Sachs Group Inc. (GS), Cantor Fitzgerald & Co., and hedge fund Two Sigma have also been trying to break in to that area.
The wholesalers profit by funneling the retail orders through their internal computers to match them against trades from professional investors. In a review in 2010, the Securities and Exchange Commission found that, of eight large retail brokerages, nearly 100% of their customer market orders were routed to market makers, and weren't sent directly to the market. Those orders that aren't matched are sent on to exchanges or other trading sites.
A technology glitch and resulting $440 million trading loss at Knight on Wednesday prompted several retail brokerages, including E*Trade Financial Corp. (ETFC), as well as big money managers, including Fidelity Investments and Vanguard Group Inc., to funnel customer trades away from Knight Thursday and Friday, opening the door for its main wholesaling rivals to pick up share.
"The most logical beneficiaries of this would be Knight's direct competitors--other market makers--who may see increased order flow because of this incident," said Sang Lee, a co-founder of consulting firm Aite Group.
"Presumably, they would be able to divvy up the market share that perhaps Knight had. That flow has to go somewhere," he said.
Some firms such as TD Ameritrade Holding Corp. (AMTD) and Scottrade Inc. resumed doing business with Knight Friday afternoon after steering trades away from Knight on Thursday.
There are no known market-share rankings for the wholesalers, but Knight is believed to be the biggest, followed by Citadel and UBS, according to Justin Schack of Rosenblatt Securities.
In a sign of how market stress can influence order flow, Citadel experienced a big surge in its volume on Wednesday after Knight asked trading firms to route their orders elsewhere, according to a person familiar with the situation. The hedge fund's market-making business typically executes 20% of U.S. equity options volume and 10% of U.S. equity volume.
"If I were in the shoes of the retail brokers, I would have been spreading [the order flow] out evenly across the providers I have because I'd be worried about knock-off effects," said Adam Sussman, a partner and director of research at TABB Group, a research-and-advisory firm, referring to potential spill-over effects from Knight's technology glitch.
UBS, Citigroup and Goldman Sachs declined to comment on their market-making volume. A Knight spokeswoman wasn't immediately available.
Retail orders are attractive to big Wall Street trading operations because retail investors buy stocks for longer-term purposes and often have less information than the professional traders they are going up against.
Professional traders can reap short-term profits bouncing in and out of trades.
The payoff for retail investors is they often get a better price than they would going directly to the exchanges. The payments from wholesalers to retail brokerages for the orders is also seen as helping to hold retail commissions down.
Barclays Capital analyst Roger Freeman said Knight Capital tends to have a high market share in trading shares of smaller companies, whereas other market makers tend to not focus on those stocks.
Knight's market-making business is desirable to competitors because they focus on that part of the market. "Without Knight there providing liquidity, the bid/ask spreads, or difference between what it costs to buy or sell a stock, would widen" in smaller stocks, he said.
NYSE Euronext (NYX) recently introduced its own program that aims to attract retail orders back to the exchange. The program allows market-making firms such as Knight to offer stock prices for retail investors that are fractions of a penny better than the going market rate.
--Telis Demos contributed to this article.
Write to Brett Philbin at firstname.lastname@example.org.
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