August 10, 2012 / 5:33 PM / 6 years ago

Insight: Knight's Joyce gets reprieve but new owners want answers

(Reuters) - Through a weekend of deal-making, Thomas Joyce averted the collapse of Knight Capital, the trading firm he has overseen for a decade.

A Knight Capital logo is seen on a trader's jacket on the floor of the New York Stock Exchange August 1, 2012. REUTERS/Brendan McDermid

Now he has to prove to his rescuers - many of them friends from his long Wall Street career - that he is still the right person to lead it.

The consortium of financial firms that ponied up $400 million to keep Knight Capital Group Inc operating did so without knowing exactly what went wrong during the 45 crazy minutes on August 1 when Knight’s computers ran amok and racked up billions of dollars in errant stock trades. They had to accept Joyce’s assurance that the software problem, and the failure by management to detect and stop it quickly, would not recur.

Investors have made clear they are holding Joyce accountable for cleaning up after the costly episode, which also raises profound questions about the risks of high-speed and complex electronic markets and what to do when they get out of control.

Joyce is “going to have to take his share of the blame, where he should,” said Curtis Bradbury, chief operating officer of Stephens Inc., a Little Rock, Arkansas, firm that bought 5.5 percent, or $22 million, of the convertible shares central to the rescue.

“Everybody that invested is gonna have to make their own judgment on whether Tom stays as CEO,” he said.

Investors are asking why no one shut down the program within a few minutes of the alarm bells going off. Daniel Coleman, chief executive of Getco, a rival market maker and one of the firms that rescued Knight, said he is focused on the chain of command at Knight, not the computers.

“I just want to differentiate between some science fiction notion of a machine gone crazy and a problem that ultimately could have been caught and resolved probably more quickly than it was,” said Coleman.

Stephens’ Bradbury said one question that needs addressing is, “Did (Joyce’s) people respond quickly enough? When they saw they had a problem, what happened?”

Joyce said on Monday that he could not say who was ultimately responsible for the glitch or why it took so long to stop the flow of errant trades, but that Knight is conducting an investigation into the matter and changes would be made once it was complete. He said there was no clear timeline on when that would be.

Joyce said the problems had nothing to do with the market-making unit itself, but more with the “technology bit or the network. It had nothing to do with the algorithmic trading group or any of the algorithms used for trading.”

One Knight trader said: “It’s a very, very complex world that we’re talking about. It’s just not an on-off switch.”

As a market maker, Knight provides liquidity to equity markets by stepping in to buy and sell stocks, using its own capital to ensure orderly activity.

WHO COULD STOP IT?

What is known about the debacle is that traders spotted the problem even before the market opened. Huge volumes of orders were cued up to trade when the bell sounded at 9:30 a.m. Knight traders on the floor of the New York Stock Exchange called the back office, in Jersey City, New Jersey, but Knight didn’t seem to have realized it was the source of the bad orders.

By 9:40 a.m., NYSE officials had identified Knight as the source. It took another 20 minutes for Knight to locate the cause of the problem within its network and shut it off. It took about another 10-15 minutes for a build-up of orders that had already been sent to be completed.

As losses mounted, employees cast about for what happened and who was responsible - and who was going to stop it.

“It wasn’t any single trader, it wasn’t ETFs (exchange-traded funds), it wasn’t (the algorithmic trading group),” said one Knight Capital trader. “It really left only one group, which was the market-making group.”

Knight declined to say which group was responsible.

For now, the crisis has passed. Data from Thomson Reuters Autex shows that most of Knight’s trading business has returned, a sign that the large retail brokerages that route orders through Knight believe the problems were the result of an isolated glitch.

Several sources said Knight could have shut down its market flow to the exchange entirely, but that could have jeopardized other orders, opening Knight up to additional liability. Knight declined to comment.

Answers are likely to depend in part on what Knight finds about what went wrong. Knight said it is investigating and told clients Tuesday it also is “in discussions with external advisers in an effort to effectively assess the situation.”

Knight has said its problems arose from software it installed to work with a new system of the New York Stock Exchange, known as the Retail Liquidity Program and designed to improve markets for small investors.

It is unclear whether someone was assigned to watch the new Knight software on the day it went live.

INVESTORS PROFIT ALREADY

For their part, investors took only a measured risk in rescuing Knight. For $400 million, they got a 70 percent stake at the rock-bottom price of $1.50 a share. The stock had closed at $4.05 on August 3, heading into the weekend when the deal was struck. On Friday afternoon, the stock was trading at $2.91.

A number of executives in the investor group interviewed by Reuters expressed confidence that Knight’s problems will be resolved and that management flaws that allowed the problem to continue for as long as it did would be corrected.

Still, Joyce has a lot to prove to the investors, which include private equity firm Blackstone Group LP, Getco, and financial services companies TD Ameritrade Holding Corp, Stifel Nicolaus, Jefferies Group Inc and Stephens Inc.

Several investors said they were only able to conduct minimal due diligence on Knight’s technology before agreeing to invest money.

TD Ameritrade and Blackstone declined comment. Jefferies did not respond to a request for comment.

“All we could do was listen to management’s explanation of what happened and their viewpoint about the mess,” said Bradbury, who spent most of the weekend in a hotel room with his chief financial officer and an investment banker from his firm, staying in touch with his firm’s CEO, Warren Stephens, by phone.

“In the final analysis, we took their representation that it was a lightning strike and didn’t compromise Knight’s basic algorithms, trading systems and core competencies,” Bradbury said.

Several executives said they did the deal because they trust Knight’s reputation and management. They also wanted to help Joyce, a fixture on Wall Street for decades.

Ron Kruszewski, chairman and chief executive of Stifel Financial, said he called Joyce the morning of August 2 to offer help even before deal terms were together. St. Louis, Missouri-based Stifel bought 5.5 percent of the new convertible issue.

“Based on my due diligence, I felt it was a black swan event,” he said, using the term for rare, surprise happenings.

Even so, he said, “There are a number of questions to which there are still no answers.”

Additional reporting by Ed Krudy, Jessica Toonkel and Greg Roumeliotis in New York and Joseph Menn in San Francisco; Writing by David Gaffen and Jennifer Merritt; Editing by Alwyn Scott, Martin Howell and Leslie Adler

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