Beware Of Other Knights Lurking In Your Portfolio

Includes: GS, IBKR, ITG, JPM, KCG
by: Shrideep Murthy

In an interview with CNBC on Monday, Thomas Joyce, CEO of Knight Capital (NYSE:KCG) laid out the reason for the glitch that took the firm almost to bankruptcy courts. "It was a very simple breakdown, a large breakdown but a very simple breakdown. It was an issue with trading technology", were his exact words. A simple breakdown that cost the company approximately $440 million dollars, a number equivalent to exactly four times its net income for 2011.

The company then raised money and salvaged itself but it is the investors who took the big hit on the valuation front and have little to cheer about. The stock is down almost 70% from its pre-glitch price and it is unlikely that it will recover soon. The overhang of class action lawsuits and other penalties from the SEC will jeopardize future profits.

When computers made their foray in trading and market making they attracted a lot of awe and attention. From simplistic trading models firms forayed to pattern recognition, neural networks, artificial intelligence, dark pools, so much so, that the race has now gone far beyond itself. Of course, people make mistakes; there are simple mistakes and costly mistakes but a glitch that can cost $440 million in a matter of 15 minutes is a rarity. But the point to be noted is that these rare events are now occurring with an alarming regularity. We had the very famous flash crash and the SEC still struggles to explain it conclusively. Then we had BATS scuttling its own IPO on its own exchange! Swiss Bank UBS said it lost more than $350 million due to inefficient order execution when the Facebook stock started trading. Such frequent occurrences and the huge amount of money lost surely point to systemic issues but it is for the regulators and policy makers to sort them out. As ordinary investors we are better off looking into our own portfolios to double check if we are holding onto companies with the 'talent' to lose four times of yearly profits in a matter in minutes.

It is common knowledge that large companies like Goldman Sachs (NYSE:GS) and JP Morgan (NYSE:JPM) use algorithms for market making but they have huge capital bases to handle losses arising from an errant piece of software. Here I profile two other companies that extensively use automated software to indulge in activities where a simple glitch could cost millions and might just not get rescued if the need be.

Investment Technology Group (NYSE:ITG)

Investment Technology Group Inc, is an independent research and execution broker whose service offerings include providing Market Intelligence, Liquidity Management, Trading platforms and Data Analytics. The automated software's at ITG traded 48.8 billion shares on US Exchanges in 2011 making $0.0049 per share.

Here is what the company says about its Liquidity Management offerings:

  • ITG trade execution services include self-directed and high-touch agency trading in cash equities including single stocks and portfolio lists, futures and options and many foreign exchange pairs.
  • ITG Single Stock Algorithms access dark liquidity while simultaneously using scheduled or opportunistic strategies. ITG List-Based Algorithms manage dollar or sector imbalance, total trading risk or tracking error using automated portfolio trading with integrated dark pool access.
  • ITG Smart Router offers an alternative to routing trades that can help capture blocks of liquidity with a combination of speed and confidentiality. This router continuously scans markets for liquidity with an emphasis on capturing the quote without posting the order. ITG Smart Router uses a proprietary algorithm to quickly and directly exhaust all available quantities at the best available price level in all destinations before moving on to the next level.
  • The POSIT suite currently provides anonymous continuous matching of non-displayed equity orders to minimize market impact.

To be fair to the company they disclose the technology risk in its Risk Factors:

  • A failure in the design, operation or configuration of our technology could adversely affect our profitability and reputation.
  • A technological failure or error of one or more of our products or systems, including but not limited to POSIT Marketplace, our algorithms, smart routers, and order and execution management systems, could result in lost revenues and/or significant market losses. We operate complex trading systems, analytical products and algorithms that may fail to correctly model interacting or conflicting trading objectives, unusual market conditions, available trading revenues and other factors, which may cause unintended results.

After losing $180 million on revenue of $572 million in 2011, ITG earned $5.4 million on revenue of $135 million in the first quarter of 2012. Shareholder equity stood at $666 million at the end of the first quarter of 2012.

Interactive Brokers Group, Inc (NASDAQ:IBKR)

Interactive Brokers is a global electronic broker and market maker processing trades in securities, futures, foreign exchange instruments, bonds and mutual funds on more than 100 electronic exchanges and trading venues around the world. With respect to its market making activities here is what the company says (pdf):

  • As a market maker, we provide continuous bid and offer quotations on over 867,000 securities and futures products listed on electronic exchanges around the world. Our quotes are driven by proprietary mathematical models that assimilate market data and reevaluate our outstanding quotes each second.
  • Our strategy is to calculate quotes at which supply and demand for a particular security are likely to be in balance a few seconds ahead of the market and execute small trades at tiny but favorable differentials.

In its Risk factors, just like ITG, the company emphasizes its reliance on computer software which could cause it great financial harm in the event of any software malfunction.

More than 50% of the company's revenue came from Market making activities and it reported a net income of $11 million on revenues of more than $300 million in the first quarter of 2012.

How do you find the highlighted words in the above text? Lucrative? Alarming? Too good to be true? Probably too good to be true. And the reality of life is that things that seem too good to be true generally are.

ITG had a negative return on equity for 2011 and IBKR returned around 10% on its equity base. For investors looking to invest in safe and sound businesses investing in any of these stocks does not make sense on a risk adjusted basis.

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

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