Knight Causing More Stink Than Story

NEW YORK (TheStreet) -- The stock market has rallied to its highest level since early May on Friday, thanks to a stronger-than-expected jobs report.

Yet, we can't forget the market turmoil that ensued beginning Wednesday morning.

If you were watching, there was a shocking wave of buying and selling. Before long, many realized the stock market had been rocked by a breakdown in one of the big high-frequency computer trading programs.

It involved a financial services company that provides access to the capital markets across multiple asset classes to buy- and sell-side firms and corporations, as well as offers capital markets services to corporate issuers and private companies primarily in the United States.

It suddenly disclosed a $440 million loss associated with a computer algorithmic trading program malfunction. That's no small loss for a company of its size.

Was the unexpected disclosure a cry for help to be salvaged from a ruinous mistake or was it a set-up to be taken over before the weekend begins?

I'm referring to Knight Capital Management Group ( KCG), which said losses from Wednesday's trading breakdown were almost four times its 2011 net income and much more than analysts had estimated.

Now the firm, apparently a victim of its own market-making schemes, is exploring strategic and financial alternatives. Rumors spread Friday afternoon that it received a last-minute credit line to live to trade yet another day.

Knight's market-making segment engages in market-making in global equities and listed domestic options. A market-maker is supposed to be the person who creates the pricing for an investment and then buys or sells it if the bid or ask price has no other buyers or sellers available.

Knight primarily offers client and non-client electronic market making activities in equity securities quoted and traded on the exchanges, over-the-counter markets and option markets. Its electronic-trading platform is a big part of how the plethora of investment and derivatives markets operates.

Suddenly, an algorithm gone awry is supposed to be the reason the company has lost 80% of its market capitalization in the wake of the trading loss, only to gain some of that back after rumors circulated banks such as J.P. Morgan Chase ( JPM) may want to scoop up this crushed company.

From what I've learned, Knight is barely able to conduct some of its regular business as many of its largest brokerage partners have stopped using its services following the firm's trading issues. Various sources are reporting Knight has asked some of its big customers to back off while it assesses the damage and its options.

Also, regulators are reported to have invaded the firm's New Jersey headquarters to make sure this key player in the operation of the markets doesn't expire or implode.

As market analyst and founder Jim Cramer reported very early Friday morning: "Could this market be so powerful -- or so foolish -- as to ignore the possible demise of Knight Capital?

"This is a firm that's integral to much of retail trading, and one that is also very important in the ETF world. Knight is a company that provides such fast execution that it is used by many, many firms. It's just that most people don't know it.

"The idea that Knight is fighting for its life, and that nobody seems to care, is a sign of incredible strength or incredible foolishness. Who is on the hook to Knight? What orders haven't been processed? Who has credit agreements? Who will get hurt?"

My sense is that there's almost a mini-panic going on behind the scenes. The regulators and the biggest financial powerhouses involved at the exchanges in the U.S. are trying to keep this from being a "Lehman moment."

People are asking scary questions. "Could this happen to a bigger company like General Electric ( GE)?" If not, would somebody explain why? Are the stock exchanges safe places for investors to invest their hard-earned money (or what's left of it)?

The chart below illustrates the phenomenal reactions and volatility that have unfolded in this critically important stock in just three confusing days (which included a wild, whip-sawed Wednesday morning on all the major U.S. stock exchanges and averages). KCG Chart KCG data by YCharts

The takeaway from an investor's perspective is that something smells really bad with this "dark night" of Knight Capital. It's the same smell when a rat dies in the wall of an old tenement building. It has made many a small investor even more dubious about the credibility of the stock market's reliability.

On Thursday, I read a story whose title "'Knight-mare: Trading Glitches May Just Get Worse" sums up the potential damage incurred by this bizarre event:

"The Knight Capital trading fiasco, bad as it is, looms even worse because similar high-speed trading problems are likely to keep on roiling the markets and fueling investor mistrust.

The so-called software malfunction caused "...a surge in volume at the market's open Wednesday and violent price swings for nearly 150 stocks."

"You can only assume that these glitches are going to continue into the future," says Todd Schoenberger, managing director of the BlackBay Group in New York. "This is a huge, huge negative. It's another black eye for Wall Street. This is not good for the retail investor. How are they supposed to trust what we do?"

That, my friends, is the $64 trillion dollar question that has to be answered soon. The memory of the nightmarish "Flash-Crash" of May 6, 2010, hasn't faded, and the mess with Knight Capital reminds investors that the stock market exchanges still haven't fixed what is broken.

A few lines from the CNBC report sums it up well, "At the end of the day this could swing the pendulum toward more human interaction in the markets, more traders on the floor," says Dave Lutz, managing director of trading at Stifel Nicolaus in Baltimore. "This is absolutely going to result in some changes."

Investors can't afford to be complacent or taciturn. If this can happen to a company that makes a market for investment products on the stock, bond and commodities market, what might happen next? Investor confidence and sentiment is at stake at a time when both are nearly "dead on arrival."

At the time of publication the author had no holdings in any stock mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Jim Cramer and Stephanie Link actively manage a real money portfolio for his charitable trust- enjoy advance notice of every trade, full access to the portfolio, and deep coverage of the latest economic events and market movements.

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