Technical lapses cause re-examination of machine-based trading.
The longer-term consequences of the Knight trading incident is likely to be a reassessment by institutions of their best execution mandates, say observers.

“The immediate fallout from the Knight situation was a routing away of order flow by institutions,” said Scott Freeze, president of Street One Financial, a broker-dealer that specializes in evaluating and trading ETFs, equities and options on behalf of portfolio managers.

“A lot of people, not just large institutions but smaller registered investment advisors and money managers, are worried about the impact on execution and clearing of firms that are primarily principal-driven and use algorithms, versus those that are more high touch,” Freeze said.

While a post-mortem of such incidents is necessary, it’s important to keep them in perspective. “The approach should be forward-looking rather than backward,” said Jamie Ofschefski, director of U.S. sales at Cyborg Trading. “It’s important to accentuate the positive rather than the negative, and to focus on what can be done to improve things.”

Restoring Confidence
The next step towards restoring investor confidence is for investors to believe that regulators are receiving enough transparency to actually police the markets.

“Regulators should work with exchanges and fund managers to ensure they have the information at their fingertips to spot Knight-type problems before they spin out of control,” said Jason Scharfman, managing partner at Corgentum Consulting, a provider of hedge fund operational due diligence reviews. “Without this type of information, market participants are better equipped to police the markets than the regulators are, and the regulators are effectively left flying blind.”

Market participants stress that it’s incumbent on regulators and others to avoid a knee-jerk reaction to the market events of 2012, and instead take a more deliberate approach to fixing the problems.

“Yes, the markets are currently suffering from a crisis of confidence,” said Scharfman. “In order to fix the situation, the best approach is for market participants, fund managers and most importantly regulators to be proactive.”

“A steady stream of investment-related disappointments—in the case of the Facebook IPO and operational problems—in the case of Knight–have caused investors to be rightfully skeptical of not only the action of the markets themselves but in some of its major players,” Scharfman said.

Street One Financial has benefited from the negative publicity surrounding Knight. “It’s been a big windfall for us,” Freeze said.

Best execution, according to Freeze, means avoiding information slippage and “gaming” of orders that algorithms are generally subject to, which result in less than optimal trade execution on ETF and equity orders.

“Street One does not have a ‘one size fits all’ model and preserves identity, as well as the size and scope of ETF and equity orders, avoiding information slippage and minimizing price impact,” Freeze said.

Through GWM Group, Street One sources liquidity, without identity or information slippage, in order to minimize the market impact of the trade, to deliver a lower total cost of trading to the portfolio manager.

The approach is targeted to allow the portfolio manager an opportunity to recapture basis points on each trade.

The goal, Freeze said, is to capture “true, underlying liquidity in order to trade in a wider array of ETF products, to minimize market impact, and to create additional investment strategies that may not have been realistic previously due to low average daily trading volume or wide bid/ask spreads.”

Market Maker Role
The problems that affected Knight were caused by a software glitch in its market making operation, which is distinct from its broker-dealer operations.

“Knight’s broker-dealer desk is the best on the Street, that’s their bread and butter as far as execution and fill quality,” said Freeze. “The issues were more on the market making side, which invoked a piece of software code, a code change from an old legacy system.”

A market maker is a broker-dealer that maintains a firm bid and ask price in a security by standing ready, willing and able to buy or sell at publicly quoted prices.

Market makers display bid and offer prices for specific numbers of specific securities, and if these prices are met, they will immediately buy for or sell from their own accounts.

In addition to electronic market making in U.S. equities, Knight Capital includes cash market making, designated market maker (DMM) services at the NYSE, market making in European equities and U.S. options, and non-client quantitative trading.

With the advent of high-frequency trading, “investors must adapt to a market which often is completely under the influence of a machine, which could account for up to 60% of total volume every day,” said Jeffrey Sica, president and chief investment officer of SICA Wealth Management, an independent wealth manager based in Morristown, N.J. with $1 billion in assets under management.

‘In order for individual investors to adapt and invest with confidence, they must understand that much of the volatility in the market could be the result of a computer buy or sell program,” Sica said. “The onslaught of computer glitches has caused a significant decline in investor confidence since one glitch could wipe out a significant percentage of a portfolio.”