When Nasdaq-listed Knight Capital Group reported third quarter earnings on October 21, the numbers took many investors by surprise.
Net income at the electronic-trading provider fell in the period by 9 cents to 31 cents a share or $29.2m, versus $36.3m a year ago. Analysts had been expecting earnings of 39 cents a share.
The company cited lower market volatility and higher regulatory transaction fees for the disappointing performance.
Shares took a beating and fell 18 per cent on the day:
We bring this up because Knight Group is launching big into the European equity space this week via Knight Link, an “innovative trading model for European equities which provides institutional and retail broker-dealers with access to Knight’s unique liquidity”.
In doing so, the firm follows in the footsteps of the likes of Getco and hedge fund Citadel in developing the high frequency trading-related market in Europe.
As Knight explain:
Knight Link in Europe is based on the highly successful model Knight developed for trading in the U.S. equity markets. In the U.S., Knight Link provides access to one of the largest sources of off-exchange liquidity in the marketplace with 129 million U.S. equity shares traded daily in October 2009.
Given that US regulators have cast a scornful eye upon high frequency trading practices (in their various manifestations), European equity investors might shudder and weep, right?
Well, perhaps not. Looking back at those poorer than expected third quarter results, it’s clear they seem to defy the notion that HFT firms are raking it in at everyone else’s expense in equities. For example, commenting on the firm’s annual analyst meeting held last week Barclays Capital offered the following interpretation of the results — something that struck us as quite interesting (our emphasis):
We view NITE as a much more stable competitor within the market making realm as it is core to the company’s business. In other words, these competitive pressures go in cycles, and at present, they have intensified again, and that is impacting revenue capture.
Furthermore, we believe that the occurrence of high volume low-priced stocks has been more of a headwind than investors realize. Management noted at the analyst day yesterday that this volume has been 24% of the mix in 2009 vs. 12% in 2008.
The way this impacts NITE is in its KnightLink business where the company takes order flow from dealers (formerly called alternative liquidity providers) essentially free of charge and interacts with the flow across its entire trading platform, matching orderflow where possible, capturing bid/ask spreads profitably, and sending what order flow it does not interact with out the door to execution venues like its own DirectEdge ECN or to exchanges.
The challenge with high volume, low-priced stocks is that they are highly liquid, trading only a penny wide, and in many cases, NITE is simply passing the volume on to an ECN or exchange, incurring transaction costs. Since it is not charging for this flow, profitability is slim to possibly even negative. NITE engages in positive selection where it can, but not all dealers have the capability to interact with NITE in that capacity, leaving NITE in a position to take the “good” with the “bad” order flow. To add insult to injury, when NITE passes these shares off to third party execution venues, it incurs SEC section 31 regulatory fees, further negatively impacting profitability on flow that is not generating any fee revenue. As the mix of volume changes in no small part because of the rise in equity valuations, that pressure will subside somewhat and should help to drive the blended capture rate higher again.
In other words, the dash for trash has in some cases not been good for rebate-focused HFT strategies at all. More so, it’s allowed traditional traders to gain best execution advantage at the cost of firms like Knight.
BarCap, however, are still positive on the group. First, because they think the above is just a cyclical phenomenon and second, due to the firm’s developments in other areas — among them the multi-asset focused business Knight Direct and FX . As the analysts note Knight’s Hotspot FX business has in particular been booming:
Hotspot has seen a surge in volumes this year, consistent with strength in currency trading volumes that we have seen at larger brokers like Goldman Sachs and Morgan Stanley. During the analyst day, management indicated that October 2009 trading volume on the platform was the highest since the acquisition. We will start to see more transparency in this business early next year when the company begins to disclose monthly foreign exchange dollar value traded along with its traditional monthly metrics.
Although, on that matter of transparency:
The company did commit to enhanced disclosures and a better reporting framework to give investors more transparency into its business segments, but the new reporting will not be effective until the company reports 4Q09 earnings in January, leaving investors with a couple of months yet to wait. We had hoped that some additional granularity would be provided at the analyst day, but instead we were left with a thorough, although still general, outline of the path of $3.00.
Related links:
High-frequency firms make inroads into US futures – FT
HFT in commodity ETFs – FT Alphaville
Electronic trading and commodity prices – FT Alphaville
US broker Knight launches platform in Europe - FT