The potential sale of Knight Capital Group to electronic market-making firms a Getco LLC or Virtu Financial is a sign that the trading rivals are looking to acquire order flow in a low-volume environment, according to one analyst.
“This is all about economies of scale. Times are tough for high-frequency trading players, with volumes down. Consolidation plays in this arena make good sense,” Aite Group research director Adam Honore said in an email. Knight’s shares surged this morning following Getco’s cash and stock offering of $3.50 per share, an 18 percent premium above where the stock was trading on Nov. 27, reports Businessweek. However, the stock slipped to $3.28 in late-morning trading. Meanwhile, Virtu Financial is said to have offered $3 per share in an all cash deal. But the company’s board will need to evaluate the merits of both deals.
Honore views the potential acquisition of Knight Capital as a consolidation play in the brokerage industry, where firms are struggling with sluggish volumes and declining revenues.
“Liquidity is down, margins are thin,” Honore said in a follow-up interview. However, the cash and stock offer from Getco suggests there is upside in the market making business. “Getco is looking at it to strengthen its market position,” Honore contends. Given that Knight has enormous retail order flow, and that Getco is used to paying for order flow, that’s attractive to them, he suggests.
Knight also brings along an institutional agency execution business, options trading and the Hotspot FX trading platform. Knight has a more diversified business than the two market making firms that are in the bidding war. As a wholesale market maker, Knight brings in order flow from hundreds of retail firms including TD Ameritrade and Fidelity, a business that Getco isn’t in.
Aside from the over capacity in the brokerage industry, sources maintain it was Knight’s trading glitch in August, which led to $450 million in losses, that caused it to become a takeover target. Forced to seek a bailout from six financial firms, including Getco, Blackstone, Jefferies, Stephens, Stifel Financial and TD Ameritrade, Knight gave up 70 percent of the company.
That group provided $400 million to restore Knight’s capital after the firm accidentally released old software code into production, which then blasted unintended orders into the market.
“They had two fiascos,” Aite’s Honore says. In addition to the trading malfunction in August, during Hurricane Sandy, Knight had a power outage at its Jersey City headquarters and had to tell their clients to send orders elsewhere, he notes.
Honore says the fact that Knight stumbled makes them affordable, but he also predicts they “won’t be the last company, not by any means,” to be sold or consolidated in the current regulatory and volume environment. However he didn’t name any other firms who could be candidates for such deals.
Regardless of which firm ends up buying Knight, there will be opportunities for consolidating their businesses, which could lead to cost cutting. Comparing this to the merger of airline giants Continental and United, which had overlapping infrastructure, Honore says Knight’s acquirer will need to pick and choose the best widgets from each side.
Since colocation is essential to high-speed trading, Knight, Getco and Virtu could be running servers in the same colo facilities, which is another redundancy, Honore adds. “There’s just a ton of duplicity,” he says.
Information technology is the first place where acquiring firms look to wring out cost savings. Since Knight and Getco are both “IT-centric firms,” that’s the first place Getco would look, Honore says. And if there are businesses that Getco doesn’t know how to run, those will be left alone, he says.
“In the core equities and options spaces, firms can pick and choose who has the best toys,” Honore explains.
But will they consolidate colocation, which is the sort of the bread and butter of high-speed trading? “If you’re looking to achieve some M&A deal profits, you have to produce some cost/saving benefit in the deal structure, or people are not going to be interested,” says Honore. “They would be fools not to.”