Market Maker Prospers As Spreads Squeezed
Ben Steverman
Tue Sep 19, 7:00 PM ET
In a large room at its New Jersey headquarters, employees of Knight Capital Group watch millions of shares bought and sold each minute, billions every day, and more than 800 billion each year.
This is the hidden world of the market maker: Knight and its competitors execute trades for brokers and institutions, often by buying and selling their own shares to match the customer orders.
Knight trades in more than 16,000 equities all over the world, and it specializes in small- and mid-cap stocks that would otherwise trade at low volumes. It is the top market maker in Nasdaq small-cap stocks and in OTC Bulletin Board volume.
For years since the firm was founded in 1995 by several online brokerages, this is primarily how the company made money, by betting on the market and buying and selling its own shares at the perfect time.
Times have changed.
"The economics of the broker-dealer business have changed forever," said Chairman and Chief Executive Thomas Joyce, speaking to analysts several months after a mid-2005 shake-up of the company.
For one thing, decimalization, new regulations and other changes have made it harder for market makers to make money simply by playing the market.
Payment For Order Flow
As an incentive to drive orders their way, Knight and its competitors used to pay brokers millions of dollars in rebates, but those payments are declining. Now Knight is learning to make more in commissions and fees.
And yet competition has intensified. When deciding where to send their orders, brokers watch Knight and its competitors closely.
They quantitatively compare their execution quality -- their ability to buy and sell shares quickly and at good prices.
To keep up, Knight has invested in its technology. Computers automatically handle the vast majority of Knight's trades, and the company must constantly readjust its trading algorithms. It also must trade more efficiently, cutting the number of human traders.
Sandler O'Neill analyst Richard Repetto says this is Knight's great strength. "I think they've done an excellent job of automation," he said.
Knight has warned that competition will continue to heat up as commissions fall and other firms move into small- and mid-cap stocks, Knight's specialty.
To attract more revenue, especially from institutions, Knight is expanding into other kinds of trading where its technological expertise would come in handy.
Joyce, a former Merrill Lynch executive who has led the company since 2002, says he has tried to attract more customers by shifting Knight's culture away from a focus on trading to a focus on clients and their needs.
Knight's efforts to stay ahead of its competitors have paid off. After some disappointing earnings the first half of 2005, Knight finished 2005 with a net income of $66.4 million, or earnings of 62 cents per share.
Knight's profitability streak is now four quarters old, with earnings per share of 47 cents in the first quarter of 2006 and 29 cents in the second quarter. As always, Knight's financial results are affected by market conditions, particularly the volume of trading and the volatility of the markets.
The company is using its earnings to finance acquisitions of smaller companies that might help it expand into new trading areas. Knight tried to enhance its business with institutional investors with the 2005 purchase of Texas-based Direct Trading Institutional. Also last year, Knight bought Attain ECN, thereby securing its own electronic communications network, which it renamed Direct Edge ECN.
Earlier this year, Knight bought Hotspot FX, which operates a platform for spot foreign exchange trading, and in July it announced the purchase of Valubond, giving Knight better access to the fixed-income market.
"They've incrementally added some companies that could help them grow in the future," Repetto said. "It's still at an early stage."
Knight still holds onto an earlier purchase, Deephaven Capital Management. The Minnesota-based investment manager is trying to expand its offering of single-strategy funds, and it is widening its geographic reach with offices in Hong Kong and London.
Last year, Deephaven managed about $3 billion in assets. The firm hoped to attract more capital this year, expecting to bring total assets under management to $3.5 billion to $4 billion in 2006.
Retaining Managers
One question mark for Knight is the future of Deephaven's management team. Knight must renegotiate contracts with Deephaven's portfolio managers by the end of the year, and Repetto said this is his "biggest concern."
Deephaven accounted for 14.2% of Knight's 2005 revenue and 22% of its pretax operating earnings.
Knight says it could not make Joyce or other executives available for interview for this article.
In July, Joyce told analysts discussions were ongoing. "We continue to feel optimistic about where it's going to turn out," he said.
Perhaps the biggest open question for Knight is whether it will continue to successfully navigate a fast-changing sector.
Knight executives say they are confident, citing the company's technology and customer service as ways to capitalize on a variety of changes on the horizon, from changes to the listed stock market to unbundling of brokerage services. "We're a force to be reckoned with," Joyce said in making his firm's 2006 forecasts last year. "Few have our depth and breadth" of offerings. |
