<<As Mr. Burnham puts it, "Nasdaq has been transformed from market where people make money off spreads to one where people make money off information. When the market was so much more fragmented, it was hard to be right. But when you have 30% of the order flow, you can make some damn good guesses." >>
Staff Reporter of THE WALL STREET JOURNAL
When Egghead.com Inc. released good news early one morning in December,
before the Nasdaq Stock Market opened, many online investors thought its
stock would open higher. Kenneth Pasternak knew it would.
Mr. Pasternak sat before a screen at Knight/Trimark Group Inc., a market
maker whose job it is to execute trades. His screen showed that orders to buy
Egghead exceeded orders to sell by 100,000 shares. Because it would be
Knight's job to fill those orders, Mr. Pasternak quickly went to work, buying
up 50,000 shares in informal trading before the market opened. When it did
open -- with Egghead sharply higher -- he sold them to online buyers, nailing
a quick $15,000 profit.
Most online investors know little about Knight, but Knight knows a lot about
them. In five years since its founding, Knight has ridden the online-trading
explosion to become the country's largest market maker, executing a huge 21% o
f Nasdaq dealers' trading volume (and a third of the smallest issues), as
well as 7% of volume in shares listed on the New York Stock Exchange.
Seeing all those orders gives Knight what Mr. Pasternak, its chief executive,
calls an "informational advantage": exclusive intelligence on which it can
trade for its own profit. "We're smarter than the market in aggregate and
we're able therefore to make a determination whether the stock will go up or
down," he says.
So even as Knight executes the trades of thousands of amateur day-traders,
the firm is, in effect, a day-trader itself. Most of its nearly 400 traders
are paid solely on the basis of profits they earn for the firm. As a
day-trader, Knight is surely one of the most successful: It hasn't had a
single losing day this year.
Moreover, unlike most of the online brokerage firms it serves, Knight is very
profitable. Its net income more than doubled to $168 million last year, and
its stock is up sevenfold in the 20 months it has been public.
All this success is a magnet for both admiration and criticism. "They've
built a great firm in terms of automating processes and serving people," says
Bill Burnham of venture-capital firm Softbank Capital Partners. But, he
complains, the people at Knight are "taking information about retail
customers' intentions to trade and using that information to improve their
own proprietary trading profit, at the expense of their customers and of
other participants in the market." Similar criticism is leveled at other
market makers who fill orders from discount brokers' customers, such as
Schwab Capital Markets, a unit of Charles Schwab Corp.
Knight is hardly alone in trying to profit from the prices at which it trades
with its customers. But Knight's end-customers aren't big institutions but
mostly small investors, often not aware of the mechanics of order execution.
Nor do they have any choice in the matter, because many major online brokers
send all their orders in particular stocks to Knight or another such firm for
execution, in return for payment.
Brokers defend this practice by praising Knight's service. The firm has "very
robust liquidity, their service and support have always been good, their
speed of execution is right up there," says John Chapel, head of U.S.
brokerage operations at broker TD Waterhouse Group Inc., which sends about
half of its Nasdaq orders to Knight.
As for Knight, it deserves no criticism, Mr. Pasternak says. He argues that
Knight, by promising to buy when investors want to sell and to sell when
investors want to buy, is giving them free and valuable access to its
capital, plus instant execution of most orders at the best price posted in
the country.
Mr. Pasternak wasn't among the Wall Street chiefs debating the stock market's
structure before the Senate Banking Committee earlier this week. But he had a
lot to do with why they were there. His firm, more than any other, has
thrived on the fragmentation of stock trading that most of the chiefs
bemoaned. It has done so by, in effect, becoming the biggest fragment.
It happened almost by accident. Mr. Pasternak studied to be a teacher but
taught just one semester before quitting to join a market-maker firm. In
1995, he and a colleague, Walter Raquet, set up their own market maker, which
evolved into Knight. They made more than a dozen discount brokers co-owners.
The pitch was twofold: If the brokers sent the firm their orders for
execution, they would benefit both indirectly by their ownership, and
directly by the payments the firm made for their "order flow."
The subsequent explosion in online trading would have been enough to make
Knight a success. But something else crucial happened. Nasdaq market makers
historically profited from the spread between the bid price at which they
bought stocks from customers and the offer price at which they sold. But in
1997, a federal probe of dealers' practices resulted in new rules that
squeezed these spreads. The squeeze was made tighter still when stocks began
trading in sixteenths instead of eighths.
With profitability collapsing, many dealers stopped making markets and sent
their Nasdaq orders to "wholesalers" such as Knight or Schwab Capital
Markets, which make markets in thousands of stocks for other brokers. Such
firms, Mr. Pasternak told investors in the 1998 prospectus to
Knight/Trimark's initial public offering, would no longer profit primarily on
spreads. Rather, they would "take advantage of the profit opportunities
represented by each trade."
As Mr. Burnham puts it, "Nasdaq has been transformed from a market where
people make money off spreads to one where people make money off information.
When the market was so much more fragmented, it was hard to be right. But
when you have 30% of the order flow, you can make some damn good guesses."
Mr. Pasternak concurs. Computers automatically fill the vast majority of
orders Knight is charged with executing, leaving most of its 393 traders free
to try to take advantage of the information these orders reveal about the
market.
The trader ethic begins with Mr. Pasternak, who mixes the jargon of financial
theory with the expletives of a trader. Seated in a vast trading room in a
Jersey City, N.J., tower overlooking lower Manhattan, the 46-year-old CEO
explains that Knight profits by combining many bits of information about
market trends with calculated risks.
Oracles and Eggheads
One morning last summer, Oracle was trading at $34. What would happen if it
fell a point? Mr. Pasternak opened his file of limit orders, those that can
be executed only if the stock hits a price the customer specifies. There were
13,000 shares' worth of buy orders between $33 and $34, but orders to sell 2
1/2 times that many shares between $34 and $35. Knowing of this selling
pressure, Mr. Pasternak would hesitate to buy Oracle, and he might even sell
it short, betting on a decline.
Or consider that Egghead morning, late in December, when the company put out
the news that it ranked in the top 10 e-commerce sites. Faced with a
100,000-share imbalance of buy orders over sell orders, all of which Knight
had to fill, Mr. Pasternak bought half that many Egghead shares in unofficial
pre-opening trading, which takes place mostly among brokers and other
institutions.
That would take care of half of the buy orders, but now he still was
obligated to sell 50,000 more shares to online investors. He didn't own them.
So he decided to go short-selling the investors 50,000 Egghead shares that
Knight had borrowed, to be replaced later after a hoped-for fall in the
price.
The move looked smart as the stock weakened slightly just after the opening.
"I was informationally advantaged," Mr. Pasternak says.
But then it turned dicey. A second wave of buyers sent Egghead shares
climbing. Knight at one point had a paper loss of $250,000. But the stock
slid sharply by the end of the day. Knight made a profit of $100,000.
But what about small investors? Softbank's Mr. Burnham says that while buyers
got Egghead stock at the opening price, as promised, perhaps that opening
price would have been lower if not for Mr. Pasternak's heavy pre-opening
buying. "Kenny wouldn't have bought those 50,000 shares if he didn't know
they wanted to trade at the open," Mr. Burnham says. "He used their own
information against them."
Crossing the Market
Knight promises to execute, at the day's opening price, the first 250,000
shares' worth of buy orders sent to it before the opening bell. But other
traders say that before the opening, wholesalers -- and Knight in particular
-- regularly use aggressive trading tactics to push a stock up or down to
favor the positions they will have to take when they execute the orders. All
the wholesaler "cares about is getting the stock up to a level where he can
fill all his orders profitably," says Matthew Johnson, head of Nasdaq trading
at Lehman Brothers. But "where it opens is not necessarily in the best
interest of their customers."
In normal markets, the highest bid (to buy) is just below the lowest offer
(to sell). Yet it's not uncommon, traders say, for Knight to bid more for a
stock than the lowest offer to sell it, and to offer to sell a stock for less
than the highest bid to buy it -- an anomalous situation known as "locking"
or "crossing" a market. This anomaly leaves the best-priced order unfilled.
But it forces the market in the direction the firm wants it go. Nasdaq
restricts crossing during the day but permits it before the opening.
"It's not unusual to see the large wholesale firms leading the pack on some
of these locked and crossed markets on most openings, and clearly Knight is
the name that's pre-eminent," says Patrick Ryan, president of Ryan, Lee &
Co., a small brokerage firm in Washington, D.C. Still, he says the problem
results more from the behavior of Knight's end-customers than from Knight
itself. If Knight is "sitting there with unsolicited orders from a group of
gamblers -- who figure 'P.T. Barnum was right, if I pay $90, someone will pay
$92' -- clearly it's buyer beware."
Circling theglobe
Consider the day theglobe.com went public, in November 1998. The new issue
was priced at $9 a share. Small investors swamped dealers with orders to buy
at the start of trading. Shortly before the opening, Nasdaq records show,
underwriter Bear Stearns & Co. was offering to sell shares at $70. Yet
shortly afterward, Knight bid $75 for them. Then Schwab Capital Markets bid
$80. Bear lifted the price at which it offered to sell shares several times,
finally to $90, but Knight and Schwab again bid even more than the offer
price.
The shares opened at $90, and within minutes, Knight executed purchase orders
by selling more than 450,000 shares at $90, Nasdaq records show. The stock
got as high as $97 that morning, but closed the day at $63.50. Many investors
were shocked by how much they ended up paying.
Schwab Capital Markets President Lon Gorman says there was an "irrationality"
in the market that day, and he has since led an investor-education campaign
"to make sure that never happens again." Speaking more generally of the critic
ism of wholesalers, he says: "The notion that there's something going on in
the back room, that you get an execution that's inferior, is totally bogus."
As for Knight, Mr. Pasternak says it loses money almost every morning because
of its guarantee to fill orders at the opening price. That crazy morning, he notes, the buy
orders that market makers had to fill at the opening bell
exceeded all the shares in the IPO. Mr. Pasternak says he will occasionally
place a bid higher than the offer "if I don't like how the market is
pricing."
Knight promises online brokerage firms that when it gets an order, it will
automatically execute it at the best price anywhere, even if it's not
Knight's quote. To execute buy orders, for example, the firm buys shares and
keeps them briefly in inventory, risking a price decline before it gets rid
of them.
But Knight takes steps to limit its risk. For example, it chooses whom to
trade with. Mr. Pasternak welcomes the "uninformed" orders of thousands of
individual investors, because he is confident that, on average, Knight will
be smarter than them. And just as a casino bars gamblers who consistently
beat the house, Knight's systems watch for investors who consistently make
money trading against the firm. For such a customer, Knight may restrict or
suspend the promise to automatically execute all trades at the best price
posted anywhere.
Knight also occasionally suspends this promise during "fast markets." Suppose
a mention on CNBC triggers a surge of buying or selling in a stock; Knight
can suspend automatic execution after it has accumulated a long or short
position of, say, 25,000 shares. Then it switches to manual execution and
fills orders only against another customer or another dealer -- a slow
process during which the stock may move a lot.
Knight tells online brokers when it has restricted automatic execution, but
the brokers typically don't notify investors. In a volatile market, an
investor may not get his order executed for several minutes.
Christopher Vu of Houston entered a market-price order for 10,000 shares of
Books-A-Million with broker Brown & Co. one day in November 1998, with the
stock at just over $29. Brown sent the order to Knight, but Knight didn't
fill it -- that is, sell Mr. Vu the shares -- until six minutes later, some
at $37 and the rest at $38.
With the stock just below $40, Mr. Vu, who thought he had bought the 10,000
shares but wasn't sure, sent an order to sell them. Five minutes after
receiving that order, Knight executed it -- at $33.50. Mr. Vu, who had
expected a $9,500 profit, lost $4,500. "I was totally taken aback," he says,
adding that he wasn't aware Brown didn't execute orders itself.
While his order was awaiting execution, trades took place elsewhere at better
prices, notes Mr. Vu's lawyer, Philip Aidikoff, in an arbitration against
Brown. He argues that a broker that doesn't go to other venues -- having
agreed to send orders to a single market maker -- may be breaching a
fiduciary duty.
Brown says Mr. Vu has no case, because Brown didn't do anything to slow the
execution, and Knight's service wasn't in any way defective. A spokeswoman
for Brown's parent company, Chase Manhattan Corp., adds that Knight is
"consistently one of the best in terms of their execution speed." Mr.
Pasternak says that he isn't familiar with this case, but that such incidents
typically arise when automatic execution is suspended; he says he would like
to find a way to notify investors when it is.
Regulators and some Wall Street firms are increasingly wondering if dedicated
order-flow arrangements are hurting the quality of the markets. Such deals
enable a firm like Knight to "cordon off" a portion of the market that only
it can see and trade with, says Ed Nicoll, CEO of Datek Online Holdings Corp.
That means Knight's customers don't benefit from competitive bidding by other
investors that might improve their price or force Knight to improve its
price, he says.
Mr. Nicoll's firm is a competitor to Knight through its Island ECN. Electronic
communications networks, unlike market makers, merely display customer
orders, against which other customers can trade directly. They don't pay
brokers for dedicated order flow, and they don't make trading bets.
Mr. Pasternak says ECNs don't provide what individual investors want and what
Knight provides: certainty of execution, at the best price anyone is posting,
and the rock-bottom commissions that payment for order flow helps make
possible. "Put a button on everyone's computer," he suggests, "an ECN choice
and market-maker choice -- and let the customers choose." |
