Takeaway From Knight Capital: Invest In The Market, Not The Exchanges

 |  Includes: CBOE, CME, FB, ICE, JPM, KCG, NDAQ, NYX
by: Skyler Greene

It's said that you can't teach an old dog new tricks, and based on recent events in the market, it certainly seems that's true. After JPMorgan's (JPM) "Whale" of a loss, we learned that excessive risk-taking at banks isn't quite over. While CEO Jamie Dimon responded well, cleaning up the departments involved and clawing back pay, the truth is that a multibillion dollar loss still happened.

Elsewhere in the financial system, the Facebook (FB) IPO was a debacle that has led to lawsuits against Nasdaq OMX Group (NDAQ). And, of course, we have yesterday's fiasco wherein Knight Capital Group (KCG) lost $440M in a mere 45 minutes - for context, that's more than KCG's profits over the last two years.

In addition to the financial crisis of 2008 and the European sovereign debt situation, such devastating (and highly visible) breakdowns in the fundamental operations of exchanges are a large part of why the stock market is widely hated.

Here's the truth. While Internet billionaire and Dallas Mavericks owner Mark Cuban might be a bit eccentric, he does know a thing or two about code. So while his hatred of HFT might be a little extreme, he does have some valid points:

The only certainty in the software world is that there is no such thing as bug-free software [...] And BATS couldn't get their software right for their own IPO. Why? It should be easy. They've been doing IPOs in electronic markets for years. Why did it fail now? If they can't get an IPO they completely control right, does anyone really think that the software that controls the hundreds of millions of human-free interactions a minute is really bug free and cannot fail? How many times an hour are there failures across individual equities around the world because of software running algorithms battling each other for supremacy to make a profitable trade? We have no idea. It's not a question of if or when we have meltdowns, it's just a question of how big and where.

While investors are protected to a degree - the NYSE is canceling trades in six affected stocks - there's one question still remaining. Why would anyone invest in market makers?

Think about it. Knight is facing a potential bankruptcy, all caused by a single glitch. And as Cuban said, no software is without glitches. The risk/reward ratio seems pretty bad for companies like Knight, Nasdaq, NYSE Euronext (NYX), Intercontinental Exchange (ICE), CME Group (CME), and CBOE Holdings (CBOE). These are all companies that could be fatally damaged by a single software glitch. With literally thousands of other companies out there that aren't at risk of being wiped out by high frequency trading in 45 minutes, why would you invest in these?

If someone can explain the attraction and lay out a solidly reasoned case for investing in market makers, I'd be happy to reevaluate. But until then, I simply see no reason for any rational investor to pursue these stocks.

The rewards don't justify the risks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.