Get more order flow, now.
That’s what industry observers say is driving the two market-making and electronic trading firms that have submitted offers to buy Knight Capital Group, the high-profile firm that suffered a nearly fatal self-inflicted technical wound in August.
The market-making business is ripe for consolidation because of sluggish trading volumes, say industry analysts. Volume on the ten major national exchanges in the first ten months of this year is down 28%, according to statistics compiled by the Securities Industry and Financial Markets Association.
So the potential purchase of big liquidity provider Knight Trading—by either Global Electronic Trading Company (Getco), or New York-based Virtu Financial—makes sense as a means for either firm to pump its own trading volume back up, according to industry analysts.
“It really has more to do with acquiring more scale more than Getco is good at one thing and Knight is good at something else,” says Adam Honore, research director for Aite Group. He notes both Virtu and Getco are high-frequency market makers and designated market makers on the New York Stock Exchange and NYSE MKT, formerly the American Stock Exchange or NYSE Amex.
On Wednesday, Knight disclosed to the Securities and Exchange Commission that Chicago-based Getco had made a bid for the brokerage (See below:” Knight, the Huge Liquidity Prize”). But it would not comment on the bid, which basically equates $3.50 a share and could end up with a final price tag of $1.4 billion to $1.8 billion in a stock and cash deal. Virtu submitted an all-cash offer of at least $3.00 a share, according to multiple press reports. But Knight has not yet filed any report describing a Virtu bid to the SEC.
Virtu and Getco are similar firms and have the most to gain in buying Knight, say Honore and other experts.
“Both specialize in electronic market making. They both emphasize algorithmic high speed trading and market making,” said an industry observer who couldn’t be quoted by name, but who knows the three firms very well. He said either firm would benefit from picking up Knight because it would provide much more volume.
“Getco sees this as a way to expand their footprint. They want it so they can acquire a lot more flow,” adds Keith Ross, chief executive officer of PDQ, a Chicago-based dark pool operator. He said that Knight’s systems would improve Getco’s ability to trade more efficiently. (See below: “What Is Getco?”)
“I interpret that bid as a long term commitment by Getco to create value in the new company,” according to Ross. Honore said that Getco is very similar to Jersey-City based Knight except it is smaller.
“There’s would be a lot of synergy if you put the two together,” he adds. “You’ve got Knight with some key strengths in the FX space. You have Getco with some strength in the futures and options markets. You get that synergy between New Jersey/New York and Chicago.”
“They (Getco) trade in everything. They specialize in being fast and they build their own systems themselves,” Honore said. He noted that Getco is a high-volume trader in both equities and options.
The jewel in the Knight crown is market-making operations, while institutional equities and fixed income trading, operations handled by human intervention, “are the dogs of Knight Trading,” said one industry source who declined to be quoted by name.
The recent financials would seem to support that. Knight market making operations had a pre-tax earning of $51.1 million in the first half of this year. That was 86 percent of the company’s total earnings, according to Knight’s financial statement. Electronic execution services had pre-tax earnings of $23.6 million while the corporate division had a pre-tax loss of $22.5 million in the same period.
KBW analyst Niamh Alexander, in a research report last week, wrote that a sale of the market making division “could make sense strategically if the unit is for sale.”
Knight, a huge liquidity provider to institutions, is also considered a desirable acquisition target because it also attracts a lot of retail order flow. That would be a help to any HFT firm, industry observers say.
”They (Getco) would get Knight’s retail order flow from the Ameritrades, Scottrades and E-Trades. That would be very helpful to their model,” an industry observer added. “The second thing is they become more public, which is what they’ve wanted to do. And finally, there would be a lot of cost savings.”
If either Getco or Virtu (See snapshot, below) eventually buys Knight, Honore said there will many overlapping operations.
“You will have co-location facility overlap, proximity hosting, telecom overlap,” he said. “So there’s a lot of opportunity to cut costs in technology,” Honore says.
Getco already owns about a quarter of Knight and its offer, if accepted, would give it control. Getco is one of six firms that bailed out the giant market maker on August 1. That’s when it sustained a $547.6 million loss owing to a newly introduced algorithm, which sent out waves of erroneous orders to the nation’s exchanges.
One factor that could delay the deal is a potential fine from trading algo trading disaster last summer. “The SEC wouldn’t block the sale,’’ one expert close to the company said. “But, if I had to guess, I would say they’re going to impose a substantial fine on Knight for not having effective risk controls.”
Honore says Getco is most logical candidate to buy Knight. However, given Knight’s huge liquidity capabilities, almost any firm could benefit from buying it.
Why?
“What everyone is after now,” he adds,” on these thin margins is volume.”
Knight: The Huge Liquidity Prize
Knight Capital Group
U.S. Equities Market Making, Knight Direct equity and Hotspot FX foreign exchange volume statistics for the month of October 2012.
Knight U.S. Equities Market Making volumes
• Average daily U.S. equities market making volume traded in October 2012 was $20.0 billion, up approximately 3.2% from $19.4 billion in September 2012 and down approximately 27.3% from $27.5 billion in October 2011.
• Average daily U.S. equities market making trade volume in October 2012 was 2.6 million, down approximately 1.9% from 2.7 million in September 2012, and down approximately 37.2% from 4.2 million in October 2011.
• Average daily U.S. equities market making share volume in October 2012 was 2.7 billion, down approximately 16.5% from 3.2 billion in September 2012, and down approximately 6.5% from 2.9 billion in October 2011.
Knight Direct
Recorded average daily equities share volume in October 2012 of 200.6 million, down approximately 2.0% from 204.7 million in September 2012, and down approximately 5.0% from 211.1 million in October 2011.*
In U.S. equities there were 21 trading days in October 2012, 19 days in September 2012 and 21 days in October 2011.
Knight Foreign Exchange
• Hotspot FX recorded average daily notional dollar value traded in October 2012 of $22.7 billion, down approximately 11.9% from $25.8 billion in September 2012, and down approximately 33.4% from $34.1 billion in October 2011.
Source: Knight Trading Group
What Is Getco?
Getco was founded in 1999 by Stephen Schuler and Daniel Tierney, former floor traders in Chicago. It has 300 employees. The firm’s primary business is electronic market making, though it also provides execution algorithms and a dark pool through its client services arm, GETCO Execution Services.
GETCO trades in over 50 markets in North and South America, Europe and Asia. The company says it is consistently among the top 5 participants by volume on many venues, It also has offices in New York City, London and Singapore. It is also an investor in the electronic exchanges BATS Exchange, Chi-X, NYSE Liffe U.S., Eris, and ELX.
Source: Getco
What is Virtu?
Virtu Financial is an electronic trading firm and market maker on numerous exchanges in equities, fixed income, currencies and commodities. Its market making is designed to lower costs for both retail and institutional investors who trade on public securities and commodities exchanges. Since 2008, Virtu’s business has grown to comprise a significant market share in several asset classes.
Virtu is as much a technology company as a trading company, the company says. It largely uses proprietary technology. Virtu develops and employs proprietary software that automates liquidity provision and trade execution through a focused collaboration between traders and developers.
The Virtu family of companies is privately held and includes Madison Tyler, Madison Tyler Trading (MTT), Madison Tyler Energy and Commodities (MTEC), and EWT. Virtu and its affiliates are members of the NYSE Euronext, NASDAQ, the Chicago Mercantile Exchange (CME) and about 25 exchanges around the world.
Source: Virtu
