What Should Have Happened to Knight

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When people go to gamble, say in Las Vegas or Atlantic City, they arrive with high hopes and a false sense of caution. With a bit of skill, a dose of luck, and one too many vodka tonics, it seems possible to beat the house. Well, if this was ever you, you know the end of the story -- you come away with less dignity than a Paris Hilton DJ show and with a much thinner wallet. For a lot of us, this is the learning curve. We realize at that point, "This probably isn't the game I want to play," and from then on trips to Vegas consist of pool parties and maybe a quick walk through the slots. If you go back to the tables, you deserve the ensuing bankruptcy. This theory applies to the gambling man, but it should apply to the gambling Wall Street firm as well.

How to lose money incredibly fast
Have you ever lost $440 million in less than an hour? Me, too. Now, to be fair, it wasn't all Knight Capital's (NYSE: KCG  ) fault. On that dreadful money-evaporating day, the New York Stock Exchange (NYSE: NYX  ) also launched its new Retail Liquidity Platform, aimed at taking back some of the trading volume siphoned by firms such as... Knight Capital. Glitches and various technical hoopla caused Knight to almost go night-night.

Luckily for them, Goldman Sachs (NYSE: GS  ) threw the company a $400 million bone, and Knight continues to make markets and play the role of "house" day in and day out.

Good for the goose, terrible for the gander
What is good for Knight is doing the market at large a disservice. For once, a market player like Knight needs to experience what the retail investor and the gambler experience -- a true loss. That way, and only that way, will incentives align on Wall Street to clean things up. If you have been following the financial news at all for the last 200 years, you could see the pattern that big money and regulation are in an eternal game of one-upmanship. Regulations come into play, the corporations find a way around it, regulators reregulate, so on and so forth.

Knight is not the most evil firm on the Street, and who am I to judge...? This isn't a witch hunt; it's just a call for justice. If I screw up and my gin-soaked human brain dumps my equivalent of $440 million in 45 minutes, I lose that money and no one is going to come give me a tissue. It's the same result if I go back to the tables feeling lucky.

Knight’s shareholders were highly diluted after the incident but Knight should have gone under. Not because it's a fundamentally bad company, not because management makes too much money, not even because the company basically plays both ends of the stick and profits no matter what -- Knight should have gone under because that's what it takes to wake people up. Maybe the high-frequency trading firms would have said, "Oh, we can lose," instead of, "Well they screwed up, but we all make mistakes." You don't hear that leaving the Las Vegas airport.

Tough love
(NYSE: UBS  ) wants its money back from the Facebook IPO disaster. The securities giant is suing Nasdaq for the $365 million it lost. I'm sorry, UBS, but this is how the thousands of retail investors who bought in on the IPO feel, too. Except they don't have the luxury of billion-dollar law firms at their disposal.

UBS needs to feel this loss, even though it's not enough to really shake things up. Once these firms start feeling the pain, then we will see some real change on the Street. In the rare event that Washington finds a way to accomplish something, don't expect the clouds to clear -- they will just rearrange into new formations that still rain down on Main Street every trading day of the year.

This is a dour editorial, and I don't think investing in equities is the same as blackjack. Those who follow the Foolish way of investing in the long term in quality companies will circumvent the market as a whole because even it cannot keep quality businesses from doing what they do best. But if you come up to your computer tomorrow morning thinking, "What am I going to do in the market today?" be careful. I hear there is a 100% chance of rain.

For a primer in long-term, Peter Lynch investing, check out the free report on three stocks Wall Street is too rich to notice. Your revenge can be your returns.

Fool contributor Michael Lewis owns none of the stocks mentioned above. You can follow him on Twitter @MikeyLewy. Motley Fool newsletter services have recommended buying shares of NYSE Euronext and Goldman Sachs Group. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (7) | Recommend This Article (9)

Comments from our Foolish Readers

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  • Report this Comment On August 09, 2012, at 5:48 PM, constructive wrote:

    This article's disregard for facts displays TMF's lack of quality control.

    Jefferies, TD Ameritrade, Getco, Stifel, Blackstone, and Stephens made up the consortium which invested in Knight. Goldman Sachs merely acted as advisor.

    Knight had tangible equity of over $1B before the loss, so it's nonsense to suggest that a $270M trading loss (after taxes) "should" have bankrupted them.

    Knight shareholders obviously did suffer a "true loss" and multiple Knight employees will probably lose their jobs over this mistake.

  • Report this Comment On August 09, 2012, at 7:08 PM, XMFMadMardigan wrote:


    Not sure what disregard for facts you are referencing. Whether Goldman gave them the cash or arranged for the financing, the statement still stands, so...yeah

    And if it werent for the financiers, the company would have had to shut down, as they themselves stated multiple times.

    I can post some links too

    Knight sh's did in fact suffer a real loss, you are correct. that also goes against nothing that I said, in fact it supports it.

    Knight's (and other big firms, not just them) market making plays both ends of the game--it has nothing to do with the value of a business or in fostering the basic tenants of capitalism. It is completely self serving, enriching a privileged few at the cost of thousands.

    In the meantime, the little guy loses 100% of the time when s/he tries to play.

  • Report this Comment On August 09, 2012, at 7:47 PM, matthewluke wrote:


    "Knight should have gone under. Not because it's a fundamentally bad company, not because management makes too much money, not even because the company basically plays both ends of the stick and profits no matter what..."


    "Knight's (and other big firms, not just them) market making plays both ends of the game--it has nothing to do with the value of a business or in fostering the basic tenants of capitalism. It is completely self serving, enriching a privileged few at the cost of thousands."

    Forgive me (and I could very well be mistaken) but it seems like you are contradicting your previous statement. Could you elaborate a bit? Thanks.

  • Report this Comment On August 09, 2012, at 8:42 PM, XMFMadMardigan wrote:

    I think I was a bit unclear in the first statement, though I can explain:

    A market maker, such as the NYSE, Knight, and many small shops, provide a framework for our daily trades to take place. They find buyers and sellers, and take a profit from facilitating the deal. That, to me, makes sense and is a integral part of the market.

    I don't particularly care if executives in a company are making lots of money. If you run a good business and act in good faith (both vague terms, I apologize), you deserve your riches. For examples of this, I look at John Mackey (Whole Foods), Warren Buffett, and Yvon Chouinard (Patagonia).

    The most unclear, and what I assume you are directly referencing, is the last leg of the statement. I would go back to my first point and say that market making itself is a necessary part of the business.

    But when a company like Knight buys and sells million of shares of a company and then dumps it to make a penny/share, it isnt accomplishing anything for the market, or the economy. And when a mistake is made, the shareholders, as megashort noted, pay.

    I apologize for sounding contradictory, I should have made my point more succinct and lucid.

  • Report this Comment On August 09, 2012, at 8:59 PM, matthewluke wrote:

    Okay, I understand your point better now. Thanks for the elaboration.

  • Report this Comment On August 09, 2012, at 9:33 PM, useless33 wrote:

    It was a great article. The fundamental premise is correct. HF traders do nothing to enrich society, the economy, or further the engine of productivity within America. I prefer the open reference to the "vampire squid", which siphons talent that could've gone into the next Ford, Apple, Standard Oil, Du Pont, or myriad other names that are synonymous with American business.

  • Report this Comment On August 10, 2012, at 11:09 AM, griffbos wrote:

    Okay first Meg, Goldman stepped in and bought the errorent trades at a great discount , thus has a potiental upside while Knight is still out 440 million which is what it had to pay goldman to buy the shares,

    Second thing Knight got bailed out at a huge upside to the so called saviors

    bottom line line Knight is still around becuase wall street money so a chance to make money while the retial investopr is once again holding the bag.

    third, the article talks about the nightmare day NYSE rolled out a new retail platform, was this the cause of this nightmare for Knight if so then the NYSE needs to make investors whole for thier errorent software, the issue was Knight didn't have the time to make sure if someone else was at fault to come up with money ( some reports had it about 15 million short to cover the lose) they had to pay the bill in three days, leaving who was at fault and who is paying the bill for down the road. The Knioght bailout was a bad deal sticking to to retail investors while once again Big wall streets reap the benifit.

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