In an era in which “CYA” is perhaps the most-used acronym by institutional fund managers focused on fiduciary responsibilities, its almost surprising to notice the many anecdotal remarks that point to a single-point-of reliance on Knight Capital’s role within the ETF marketplace. Some would think it “shocking” that so many institutions were caught without having a chair when Knight stopped the music and instructed their customers to trade elsewhere.
Yes, based on volume/market share, Knight had become the single-largest “market-maker” for ETFs, as well as a broad universe of exchange-listed equities. Arguably, their pole position is courtesy of pay-to-play pacts with large equity stake holders and ‘strategic partners’ who control significant retail and institutional order flow; including household names such as TD Ameritrade, E-Trade and Blackrock.
This is not to suggest that Knight Capital has not earned its designation for being a formidable market-maker within the securities industry. Their most senior executives are deservedly well-regarded by peers, competitors and clients alike, and their trading capabilities are revered by many.
And yes, Knight’s most recent travails are, to a great extent the result of a “bizarre software glitch” that corrupted the integrity of their order execution platform. There’s a reason why software is called soft-ware.
That said, this latest Wall Street fiasco–which resulted in a temporary disruption of NYSE trading and the permanent re-structuring of one of the biggest players on Wall Street who was rescued from the brink of total failure– is less about that firm being “too big to fail”, or the many spirited debates regarding “algorithms that have run amok”, or even the loudly-voiced and often under-informed shouts coming from politicians in Washington regarding the ‘pock-marked’ regulatory framework by which US securities markets operate.
This story is about something much more basic: dependence by seemingly savvy fiduciaries on a single, market-making firm that figuratively and literally trade against customers in order to administer the daily execution of literally hundreds of millions of dollars worth of retail and institutional customer orders. This happens, all despite the same fiduciaries commonly inserting the phrase “best execution” within their very own mandates, internal policy documents and regulatory filings.
Many of these fiduciaries may not truly appreciate where Knight resides in the trading market ecosystem, the actual meaning of “best execution”, or how they can achieve true best execution without being reliant on a single firm whose first priority is not to the client, but to themselves and their shareholders, who depend on the firm’s ability to extract trading profits when ‘facilitating’ customer orders as being the ultimate metric for the value of their employee bonus and/or their ownership of shares in that enterprise.
CNBC, Barrons, and IndexUniverse (among others) have been following this story closely, and we point to excerpts from a reader comment posted in response to IU’s Aug 6 column “4 ETF Lessons From Knight” by Dave Nadig:
In reply to your column today, this writer respectfully suggests there are more than 4 lessons to be learned from the brouhaha about Knight:
Lesson #5: For those who found themselves scrambling while Knight instructed its customers to “trade away” while they worked through their business interruption, the lesson of ‘putting all eggs in one basket’ should be self-evident. To date, Knight has certainly been one of the most prevalent ‘market-makers’ in the ETF space, perhaps because of pacts with TD Ameritrade and other major retail investor ‘custodians’ who, thanks to certain fee arrangements (as well as direct equity stakes in Knight) route hundreds of millions of dollars worth of customer orders to Knight. Staffed by skilled traders, and to deliver an execution, they arbitrage the price a customer is willing to trade at vs. the price that is available in the ‘wholesale market’, or the difference between the underlying components and the cash ETF; markets that custodians don’t have ready access to.
Regardless of Knight’s most senior-most executives being widely well-respected by their peers and their customers, depending on any single “provider of product pricing”, particularly when that provider ‘trades against customer order’ is counter-intuitive for any fiduciary who is obliged to secure the true best execution.
Lesson #6: Liquidity Aggregators aka ‘agency-execution’ firms are a compelling alternative for those who have come to rely on a single or short list of market-makers, especially for those utilizing ETFs that are seemingly “less liquid.” The agent’s role is to serve as a fiduciary; to efficiently and discretely canvass not only a short list of trading desks and screen-based venues, but multiple, OTC liquidity providers so as to aggregate and distill the real best price that a customers’ order can capture. The most proficient agents can prove to be invaluable because they have high-touch connectivity to a universe of liquidity providers who do not advertise themselves, but otherwise compete on pricing in more advanced/complex products.