In Defense of Knight Capital

I am not a huge fan of high frequency trading algorithms. I take a long term view for my investments because my goal is capital accumulation, not profiting off of short term changes. I also don't buy the entire liquidity argument. Is the liquidity provided worth the added volatility? I don't know the answer.

What I do know is that Knight Capital is not the enemy. I've read articles questioning the safety of computer based trading or claiming that Knight won't be the only one. These article irritate me. This is not the end of the world and I, for one, do not want to go back to the days before computers did a lot of the tedious work of market making. On the plus side Reuters did a very good job presenting both sides of the debate.

Those articles just irritate me. No one proposes going back in time, just "more regulation". And here is where I go from irritated to angry. This is pointless distraction in terms of regulation. Despite 45 minutes of reckless trading, at the end of the day the damage was limited to Knight Capital and its shareholders. This is not a systemic risk. Even the great "Flash Crash" triggered circuit breakers and ended. No big deal in the long term. I am far more concerned with the distorted incentives I can see bubbling to the surface. Especially those related to the SEC and the NYSE.

The problem with financial regulation is politics.

First, the SEC. I respect the SEC for trying to do a difficult job. I'm not sure anyone really likes financial regulation right now. The industry dislikes it for adding cost and limiting options. And everyone else dislikes its because it doesn't seem to work - unemployment still sucks, the stock market is plagued with excessive volatility right now and every week seems to bring a new scandal. That said, I think the SEC could do better. The SEC twitter feed is especially interesting. All the timely news relates to small scale operations, mostly insider trading and fraudulent funds. Anything involving a big name seems to be dated back 5-10 years. Yes, I'm very glad you got OppenheimerFunds to pay $35 million but that was for violations dating to 2008. Do these things really take this long to make a case? Can we at least charge interest on the fine? No, I'm sorry, you owe what would've been $35 million 4 years ago, here's our discount rate.

Yet the SEC can swipe at Knight Capital easily enough, I imagine their lobbying operation is negligible. Go ahead, call it "unacceptable" and use it to push for more regulation that won't matter because it is impossible to predict what will cause the nest Flash Crash, or better yet, regulation that costs more than it brings in benefits.

Let's not forget that the NYSE benefits from Knight's fall

This article points out the the NYSE threw Knight Capital under a bus by choosing to only cancel trades in a very narrow band. I tried to make sense of the decision in terms of the Clearly Erroneous Execution policy but I could only conclude that the NYSE has a great deal of discretion in what it can cancel. That would be fine except that the NYSE is a rival to Knight Capital. As this article points out, "The day Knight Capital Group's computers nearly blew up the market and lost the firm $440 million in 45 minutes is the same day that the New York Stock Exchange launched a new trading system that was, in part, meant to take business away from Knight."

The NYSE is now in a very good position to claim that what the market needs is exactly what only the NYSE is in a position to provide. How convenient. This claim may be true but the regulators need to keep in mind who profits from the rule changes before they consider this advice.

Glitchy software is not the greatest risk to the system's stability

It just isn't. Too many insiders distort returns towards their own interests. Too much regulation that benefits lawyers and established firms far more than the ordinary investors who rely on the system for retirement, mortgages, and small business loans. These are the real problems. Knight Capital Group is just a small company that made a mistake and I hope it avoids bankruptcy in the coming weeks.