Trade by Knight -Part 1
The explosion of online trading reinvented the role of market makers. One maverick firm, Knight Trading, turned that role into a new profit source–but is it fair?
From the October 24, 2000 issue Business 2.0
Loren Fox
Never been to Jersey City? Chances are, your money has. If you're one of the 14 million-plus Americans who trade stocks over the Web today, your buck probably stops here–in a spacious, 29th-floor office in Jersey City's Newport Center, overlooking the low-rent side of the Hudson River.
Here, on a sweaty afternoon, more than 200 men and women, mostly well-scrubbed 20- and 30-somethings, sit in neat rows behind computers, typing furiously, eyes glued to their screens. Not even phone calls break the constant din of keyboard clickety-clack.
But these are no $8-an-hour, data-entry office temps. They're high-priced stock traders working for Knight Trading, the nation's biggest stock wholesaler, or market maker, for Internet brokerages such as TD Waterhouse, Ameritrade, and dozens more. Knight acts as the behind-the-scenes workhorse in online trading today; more than 500,000 electronic stock-trade orders flow into Knight's digital in-basket every day, where these traders work at breakneck speed from 9 a.m. to 4 p.m., pausing only to wolf down an ordered-in lunch.
One catch: None of these young pros is working to fill your order. A patented piece of Knight software actually does all that within seconds of receiving a trade order from a Net broker, while the firm parlays its own capital to automatically fill those orders each second. Click to dump your 1,000 shares of Webvan at the posted market price, and zap–Knight software buys them up instantly.
The traders are there to monitor those thousands of incoming online orders much like air traffic controllers stalk planes, mining the constant buy and sell data–and the resulting inventory of shares triggered by automated selling–for subtle clues about the short-term direction of stock prices. Working on about 30 stocks apiece, the traders then use that information to trade on the firm's accounts and portfolios, not yours. This means one of these 29th-floor traders gladly took your Webvan shares and, more likely than not, sold them within a half-hour for a much better price.
The result is nothing short of a hugely profitable–but controversial–new market-making model, one that the Net made possible and Knight seized first in 1995. Instead of making money the old-fashioned way–capturing the slim-profit "spread" between buy and sell orders–Knight began using automated software to fill Net traders' orders instantly and accurately, and deployed its own battalion of traders to act on that information, reaping much bigger rewards.
How big? Following the '99 boom in online trading, Knight's profits more than tripled to nearly $168 million on revenue of $801 million. In the second quarter of this year alone, Knight traded 21.5 billion shares, more than six times the volume of the American Stock Exchange, and now accounts for 14 percent of Nasdaq trade volume. And, unlike the thousands of average investors it relies on for its business, Knight rarely turns in a losing day on the market–just eight, in fact, in all of 1999.
Leading the pack: Knight Trading CEO Kenneth Pasternak
Photography: Terrence Miele
This might help explain why the mastermind of this booming operation–balding, bespectacled Kenny Pasternak, Knight's 46-year-old founder and CEO–is suddenly feeling heat. While many investors and trading pros believe that wholesalers like Knight command an unfair advantage because of the wealth of market information they sit on, old-line firms such as Merrill Lynch and Goldman Sachs like what they see in the Knight model, and are spending furiously to catch up.
When online trading emerged as a niche in the mid-1990s, wholesale market makers hardly paid attention. They continued to focus instead on much bigger orders coming from fund managers and institutions, since Net brokerages then accounted for just a trivial portion of trade volume. As a result, E*Trade and other competing firms may have offered investors a great novelty back in the mid-1990s, with their anti—Wall Street bravado and trading over the Web, but their customers might actually have gotten better trade execution and prices by simply phoning in an order to a traditional broker. Net brokers eventually needed a behind-the-scenes firm to deliver competitive execution electronically.
Enter Pasternak and Walter Raquet, executives at Troster Singer, an old-line market making firm owned by Spear Leeds & Kellogg. Both shared an unpopular view for Wall Street 1995–that online trading would move quickly from retail novelty to market-changing phenomenon. That year, Pasternak and Raquet broke from the pack and started a market maker (then known as Roundtable Partners) that would exclusively serve Net brokerages' order flow. Pasternak quickly signed up a key group of 27 brokers, including TD Waterhouse, E*Trade, and Ameritrade. In borrowed office space at Waterhouse in Manhattan, Pasternak and Raquet began taking orders over the wire.
"We didn't know if they were going to be successful," recalls John Chapel, the executive vice president of Waterhouse's U.S. brokerage operation. Market making wasn't an easy club to break into, dominated as it was by investment banks Merrill Lynch and Morgan Stanley, and by a handful of independent firms.
But sooner than anyone expected, online order flow grew, enhancing Knight's liquidity, or its ability to buy and sell quickly. And because online investing has since surged in popularity, small investors–formerly buy-and-hold types who accounted for just a tiny fraction of market trading volume–now wield the cumulative power to move markets, and draw major-league liquidity.
As a result, in just three years, Knight rose to the sort of prominence that previously took market makers one or two decades to achieve. By February 1998, the firm had seemingly done the impossible–it blew by Schwab Capital Markets as Nasdaq's biggest market maker, and has topped the heap of more than 50 significant market makers ever since.
Knight beat the big Wall Street players at their own game because its business breaks from the traditional market-maker's role of simply collecting razor-thin profits, trade by trade. Under the old model, market makers would pocket the small difference between buyers' and sellers' orders: Match an order to buy 1,000 shares of stock at $10.06 per share with an order to sell at $10, and the market maker takes a total of $60 profit for his trouble. But as Net trading grew, the markets changed in a way that made it harder to profit off the spread between buy and sell orders. "Trading with spreads was slower, easier, and in many ways a lot less fun," says Randy Taylor, who followed Pasternak to Knight from Troster Singer and is now the firm's co-head of Nasdaq trading.
Nasdaq made it even less fun for traditional market makers in 1997, when it changed its rules, shrinking the spreads that market makers could scoop on each trade. Wall Street firms such as Merrill Lynch and Bear Stearns reacted predictably and scaled back their market-making operations, using them mainly to support stocks that they'd taken public.
At the same time, the Net hatched a number of all-electronic trading systems, known as electronic communications networks or ECNs (see "Don't Be (Too) Afraid of the Dark ," Jan. '00, p242), that automatically match buyers and sellers of stocks using computer algorithms. Bypassing market makers, these ECNs, such as Island, Instinet, and Archipelago, now account for roughly one-third of the trading on the Nasdaq market; competition that has further squeezed the spreads.
Knight's success is now luring Wall Street back into the market-making game. The first big move came in June, when Merrill Lynch agreed to pay $900 million for Herzog Heine Geduld, the third-largest market making firm in the United States, reversing earlier moves to scale back. (Merrill now trails Knight as a close second in Nasdaq market making, followed by Schwab's market maker division.) Then in September, Goldman agreed to buy Spear Leeds for more than $6 billion to jump-start its own market making operation. There has even been speculation that Knight is a takeover candidate.
Tom Joyce, co-head of global electronic equity trading at Merrill Lynch, says the firm could no longer ignore online investors, particularly the self-directed types not interested in Merrill's array of traditional broker services. "We thought it was important to get into that space, and we ended up buying instead of building," Joyce says. One advantage Merrill holds over Knight: It can easily route a significant share of its own brokers' order flow into its new market-making arm, which does business down the street from Knight in Jersey City.
"Knight has shown how attractive this business can be," says Gary Craft, an analyst with Deutsche Banc Alex. Brown. "This idea that market makers are dead isn't true, or else Merrill wouldn't be buying a market-making firm."
A penny for your order
Pasternak's serious demeanor cracks just a bit when he discusses his passion for trading. He laments that as his CEO duties have grown, his trading time has decreased to fewer than 10 hours a week. Even still, he's eyeing new territory–moving Knight's half-automated, half-human trading model into options exchanges and other markets. "I see no reason why Knight couldn't have a 10 percent market share in every securities market," he boasts.
If that's true, recent profits will help pave the way. In the second quarter, Knight earned $67.2 million on revenues of $313.5 million. The company may turn even fatter profits this year, because while it still handles a huge amount of retail orders, its fastest-growing business lies in trading for funds and other institutions. In fact, 44 percent of its revenue comes from institutional trades, which are more lucrative because they offer more opportunities for Knight's crack team of traders.
The big numbers help mask the growing controversy about key aspects of Knight's business model. First, Knight has always paid some brokers for sending it market orders, or orders to buy or sell at prevailing the market price. Knight pays brokers half a penny per share for certain orders on the American Stock Exchange, up to 2.25 cents per share for some orders in the S&P 100. Last year alone it shelled out more than $139 million in order-flow payments. |
