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1001 Knights: Street Whispers

Stocks in this article: KCG GS JPM MS NDAQ

NEW YORK ( TheStreet) -- Knight Capital Group (KCG)'s 15% rally on Wednesday following reports it may be acquired shouldn't blind us to the fact that its shares are still 75% off their highs of the year and that the risk of future implosions of capital markets firms is increasing all the time.

Knight was a high flier in the late 1990s. Its shares passed $70 for a brief period in April 1999. In addition to the bursting of the tech bubble, Knight was forced to adapt to a variety of forces that squeezed profit margins. Knight had revenues of $524,000 per employee in 2001 and increased that number to $984,000 per employee in 2011. Despite that increased efficiency, its shares lost 12.74% from the end of 2001 to the end of 2011.

Knight brokers trades between large institutions, or in some instances, executes the trades on their behalf. Like many of its peers, Knight increased its efficiency largely by replacing people with machines. That decision proved costly when, on Aug 1, a computer trading glitch sent numerous erroneous orders into the market, costing Knight $458 million in trading losses, and exposing it to lawsuits and regulatory investigations.

Another broker-dealer, Rochdale Securities, is also fighting for survival after a series of unauthorized trades. The issue is still under investigation, but the theory that the trade was the result of a "fat finger"--as unnamed sources told The New York Times earlier this month--suggests Rochdale's trading operations were inadequately supervised.

Despite these issues, not to mention a computer malfunction at Nasdaq (NDAQ) that marred Facebook (FB)'s initial public offering in May, capital markets firms like Knight, Rochdale and Nasdaq increasingly rely on automation in a drive to increase efficiency.

The same is true of the largest securities firms, argued analysts at Bernstein Research in a report published Tuesday on Goldman Sachs (GS), Morgan Stanley (MS), JPMorgan Chase (JPM)and other large broker dealers.

Bernstein's analysts believe "acceptable" but "not generous" trading returns are likely achievable in 2019. However, they write, "the path to profitability will be precarious and the actions pursued will be painful. Massive expense reduction, staff redundancies, new technology investments to automate client interaction, trading execution and settlement and intensive balance sheet discipline has to be pursued."

Fewer humans, in other words, and more machines. By the time we get to 2019, the trading disaster at Knight may very well seem quaint.

-- Written by Dan Freed in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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