You Need Knight Capital. Here's Why.

Among ordinary investors, confidence in Wall Street has never been lower. With a series of Ponzi schemes, the MF Global futures account debacle, JPMorgan Chase's derivative trade gone bad, and the LIBOR scandal that's threatening to suck in Bank of America (NYSE: BAC  ) and a host of other U.S. banks, it's easy to see why people don't feel comfortable counting on the financial industry to watch out for their money.

In the context of all these recent problems, the glitch that hit Knight Capital Group (NYSE: KCG  ) may seem to be just another example. But unlike the others, Knight's problems could actually pose a threat to -- and have a lasting impact on -- ordinary investors that could in turn harm their investing results.

Market-making and you
Whenever you buy or sell a stock, you inevitably deal with what's known as a market maker. Professional firms like Knight simultaneously offer to buy stock from investors at one price and sell stock to other investors at a different price.

With big stocks that have high trading volume, the market maker's role isn't quite as important. But with thinly traded issues, you may well need a market maker in order to pick up or get rid of shares. Without a market maker standing behind the stock, you'd be left without any means of making your trade.

Still standing
Those considerations may explain part of why Knight Capital was able to get a much-needed infusion of capital during the worst moments of its crisis. A variety of financial firms, including discount broker TD AMERITRADE (NYSE: AMTD  ) , private equity giant Blackstone (NYSE: BX  ) , and analyst firm Jefferies Group (NYSE: JEF  ) among others, all pitched in to contribute $400 million in exchange for 267 million preferred shares paying a 2% dividend and allowing those investors to convert shares to common at $1.50 per share.

Given the rebound in Knight stock to nearly $3 per share, the companies that participated in Knight's bailout are already sitting on a huge paper profit. But beyond that, the motivation that at least some of those buyers may have had rests more with ensuring that Knight is able to provide the services that those firms and their customers rely on daily.

Systemic risk?
It's hard to argue that Knight is an institution that's too big to fail. But the market-maker business model is one that has benefits both for Knight and for investors, particularly retail investors.

If Knight hadn't survived, the effects wouldn't have been nearly as bad as the financial crisis. But it would have caused disruptions in certain parts of the market. As a recent Wall Street Journal article describes, spreads between bid and ask prices for certain stocks that Knight made markets in could have gone up, effectively increasing the transaction cost of trading in those companies. Moreover, with less competition among market-makers, those effects could have persisted long after everyone had otherwise forgotten about Knight's failure.

Knight in particular serves customers with a number of brokerage companies, including TD AMERITRADE, Vanguard Group, and Scottrade. Given the popularity of those discount brokers among retail investors, the loss of Knight could have had a big impact on the many investors who use those brokers.

High frequency or low
In looking at Knight, many analysts have paid the most attention to the fact that a computer glitch caused the problem that created the company's big losses. Combined with other concerns about high-frequency trading, the Knight debacle helps create a Terminator-like picture of computers taking over the investing world.

But before you condemn the private bailout of Knight as another example of Wall Street helping its own, think about the impact that Knight's disappearance would have had on you. In the end, you may well be thanking the players in the financing for their willingness to step in when the future looked darkest for Knight.

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Also, Bank of America has suffered its hits from scandal, but it also has a lot going for it. Learn more by checking out our premium investment report on Bank of America today.

Fool contributor Dan Caplinger always looks for unintended consequences. He doesn't own shares of the companies mentioned in this article. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Bank of America and JPMorgan Chase. Motley Fool newsletter services have recommended buying shares of and writing puts on TD AMERITRADE, while formerly recommending JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy needs you.


Read/Post Comments (2) | Recommend This Article (1)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 16, 2012, at 9:47 AM, tenor15824 wrote:

    I disagree completely. Knight has cost small investors greatly by their ability to control the price of most small-cap stocks. In my opinion they are one of the reasons that so many individual investors have left the markets. They just cannot compete against the computers.

  • Report this Comment On August 16, 2012, at 3:05 PM, TMFGalagan wrote:

    @tenor15824 - Market-makers only control prices to the extent that they add liquidity that other market participants, including small investors, don't provide. So I'm not sure what your objection is. If you think Knight has distorted prices, then that would open up an opportunity for long-term investors. Would you explain your concern further?

    best,

    dan (TMF Galagan)

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