Online Trader Knight/Trimark, Amid a Boom, Faces Threats
By REBECCA BUCKMAN
Staff Reporter of THE WALL STREET JOURNAL
"Bill Burnham, an electronic-commerce analyst with Credit Suisse First Boston Corp., says E*Trade might send all of its limit orders to Archipelago, reserving market orders for Knight. That scenario "would have an impact" on Knight, which can use limit orders to gauge sentiment in the market and aid its own, proprietary trading, Mr. Burnham says"
Skyrocketing Internet stocks giveth. But as trading firm Knight/Trimark Group Inc. may discover, they can also taketh away.
Knight, which executes stock orders for some of the nation's biggest online brokerage firms, has seen its business boom in the past few weeks as investors have swamped Web brokers with trades. Shares of the Jersey City, N.J., company, which languished for months after Knight went public on the Nasdaq Stock Market over the summer, are up more than 180% since mid-December.
But some analysts worry that Knight's robust volume growth could soon hit a speed bump. One threat is a deal announced two weeks ago by one of its top-three customers, E*Trade Group Inc., which bought a 25% stake in a competing trading network, Archipelago Holdings. The alliance probably means E*Trade will send some orders to the all-electronic Archipelago that would have gone to Knight, analysts say. Knight Chief Executive Kenneth Pasternak concedes he was "blindsided" by the deal, though he doesn't figure business will suffer from E*Trade's move.
Another problem: Some of Knight's shareholders -- the very brokerage and trade-clearing firms that supply such a large chunk of the firm's business -- could indicate this week that they want to sell some of their shares to raise much-needed cash. Owners include Internet heavyweights such as E*Trade, Ameritrade Holding Corp. and Toronto-Dominion Bank's Waterhouse Securities Inc., all of which originally bought stakes in Knight's predecessor firm, Roundtable Partners LLC.
If firms sell shares, "they've got less incentive to route orders to Knight," since they no longer will directly benefit from Knight's growth, explains James Marks, an electronic-commerce analyst at Deutsche Bank Securities. Yet, he adds, "I would expect Knight would still get a reasonable portion of that flow."
Earlier this month, the 180-day "lockup" period during which Knight's 26 broker-owners were restricted from selling shares expired. Mr. Pasternak acknowledges that "some of the smaller broker-dealers have already indicated that they'd like to sell some of their holdings," although he declined to elaborate. Mr. Pasternak polled the owners last week and is expected to announce this week how many want to sell shares in a planned secondary stock offering.
Together, the broker-owners own slightly more than 40% of Knight's stock, with the three-largest holders, Waterhouse, Ameritrade and E*Trade, owning slightly less than 25% of the total, Mr. Pasternak says. At Knight's closing stock price Friday of $41.9375, Waterhouse's holdings are valued at $255 million. Ameritrade's original investment of $7 million has now grown into a cool $166 million.
Knight would be most threatened if some of its big-three owners decided to sell, either through a secondary stock offering or directly after some additional insider-selling restrictions expire this summer. At some point, "I'm expecting E*Trade and Ameritrade to sell all or a portion of their holdings, especially with the stock at this level," says Deutsche Bank's Mr. Marks. All online brokerage firms are facing pressure to spend huge sums on advertising and technology to stay competitive in the burgeoning industry.
Ameritrade Chief Executive J. Joe Ricketts, however, says his firm has no immediate plans to sell its stake. Still, "if we ever need cash, that's the first thing that goes," he says. Ameritrade could sell its Knight shares or file for a follow-on stock offering later this year or early next year, the CEO adds, although it would sell its Knight stock only because it needed the money -- "not because we don't think it's a good investment."
Waterhouse declines to comment, while E*Trade says it is treating its Knight holdings like any other investment. Knight shares owned by E*Trade, a firm more cash-rich than its competitors from a $400 million investment by a Japanese software company over the summer, are now valued at about $108 million.
Mr. Pasternak, the Knight chief executive, whose company also runs a business that makes markets in New York Stock Exchange stocks, doesn't figure that current customers will abandon him if they no longer are owners of his company. "We're pretty comfortable that we will earn the right to be their market maker on our own merit," he says, adding that about 50% of the firm's trading volume comes from nonowners. And if Knight continues to be the largest Nasdaq market-maker on Wall Street in terms of volume, firms will always find it attractive because Knight will offer more liquidity, or ease of trading, in hard-to-trade stocks.
That's also a reason Mr. Pasternak doesn't fear "electronic-communications networks," or ECNs, like Archipelago. Knight last year bought its own stake in an ECN, he points out, and its existing systems already perform many ECN-like functions, such as matching customer limit orders with incoming trade requests. Much of the current hoopla over ECNs is just hype, he grouses: "We should change our name from Knight/Trimark to KT.ECN.com."
Analysts and academics agree that electronic matching systems aren't best for all trade orders, many of which require a Nasdaq dealer such as Knight to intervene and commit capital. But increasingly, sophisticated online investors want to route orders to an electronic system because they think their trades will get executed faster and, possibly, at a better price, says David Whitcomb, a finance professor now on leave from Rutgers University. ECNs, unlike market-makers, aren't also trying to make money for their own accounts while executing customer orders, he notes.
"This trend is definitely going to cut the profits" of dealers, says Mr. Whitcomb, who also runs a trading firm that competes with Nasdaq dealers. He adds: "A firm as big as E*Trade taking a piece of an ECN is going to direct order flow away from folks like Knight."
An E*Trade spokeswoman says the company is still evaluating exactly how it will use Archipelago. Bill Burnham, an electronic-commerce analyst with Credit Suisse First Boston Corp., says E*Trade might send all of its limit orders to Archipelago, reserving market orders for Knight. That scenario "would have an impact" on Knight, which can use limit orders to gauge sentiment in the market and aid its own, proprietary trading, Mr. Burnham says.
Deutsche Bank's Mr. Marks sees ECNs as a threat to Knight, but only in the long term. "Right now, Knight is benefiting tremendously from the surge in trading in Internet-related stocks," he says. "That trend alone overwhelms anything else we're talking about. These other elements become a factor when these trading volumes recede."
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