What Knight Says About Other Alternative Exchanges

| About: KCG Holdings, (KCG)

The good news is that Knight Capital Group (KCG) seems set to survive last week's stupid.

But the way this is being done should be a tell of deeper problems.

KCG is getting its cash through a sale of convertible securities to a consortium of rivals including Getco LLC, a privately-held market maker and competitor to Knight. The result is that the privately-held markets Getco has brought into this deal will own 70% of Knight, Reuters reports.

As the market opened Monday Knight was trading at $2.80, well above the $1.50/share strike price on the shares being created as a result of this deal. The proper price for Knight shares, therefore, should be almost 50% lower than they are. Any value over that, it seems to me, is water.

Knight is the dominant alternative market out there, handling lots of trades for retail brokers when the NYSE (NYX) and NASDAQ (NDAQ) are closed. But while a credit card processor may have to maintain technical requirements with a credit network like Visa (V) to stay in business, the alternative markets are competitors to the majors, not affiliates.

This means that the alternative markets can impact pricing on the major exchanges, as Knight did last week, when it seems to me a test script used in its development system was run on its live system, executing multiple times and causing huge swings in the stocks listed in the script. The script was designed to simulate trading over a full week creating something akin to the "flash crash" of 2010.

While there is extensive public regulation of the financial markets, there is little control over the computers that now make those markets. As KCG heads toward the private company exit, with other market makers also privately held, the SEC and CFTC are losing their ability to control how markets are made in stocks and other securities.

The answer, it seems to me, does not lie in more public regulation, but more private regulation. That is, the boffins who run the NYSE and NASDAQ computer systems need to develop procedures and checklists that must be followed by all other market makers before their trades will be reported to the major exchanges. And the ultimate penalty for failure to comply would be the removal of their ability to connect trades to the market.

In this case, the NYSE did have a software change due, and it was in implementing the change that the script got let out. Trouble was it took 10 minutes for the NYSE to identify Knight as the cause of the problem, and another 20 minutes to turn the script off. By that time it had run multiple times, causing a huge spike in volume and price swings on the stocks in the script.

That's not good enough.

The NYSE needs to act more like Visa, MasterCard (MA) and American Express (AXP) do on their credit card processors, who do most of the heavy lifting in the multi-trillion dollar credit card industry. When Visa was hit by a problem at a processor early this year, it was quickly able to take away that processor's right to trade, and that processor is now going through an extensive, and expensive, probation process before it gets its rights back.

That's what should be happening with KCG. It should lose its ability to connect to the actual markets until it proves itself through a probationary period to be a good actor. The NYSE did pull Knight's market-making rights, but only until the capital was secured. This isn't a capital issue. It's a computer issue.

Having control of systems before something happens would prevent most problems of this kind, and mitigate those problems that do happen before a rogue script is allowed to play havoc with your investments again.

Don't stock trades deserve the same protection as credit card transactions?

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