Knight Capital is or was the largest market maker in exchange-traded funds. But the knock-on effects caused by Knights software debacle last week, dubbed the Knightmare by the Wall Street Journal, were effectively forgotten on waking.
There was an irrational trader in the system, and the market did exactly what it should do with an irrational trader, says Dave Nadig, director of research at IndexUniverse, the San Franciscobased ETF research firm. It ate them for lunch.
Nadig says that prior to last Wednesdays astounding high-speed loss of $440 million, Knight was doing a better-than-average job of maintaining tight bid/ask spreads in thinly traded ETFs, defined as those that trade less than 50,000 shares per day. Knight is the lead market maker (LMM) on 418 ETFs on the New York Stock Exchanges Arca platform, with 150 in the low-volume category, he says.
Using a universe of about 900 ETFs on NYSE Arca that have LMMs (not all do), Nadig calculates that in the two days prior to Knights August 1 meltdown, the average spread on all thinly traded ETFs was 73 basis points, but for those where Knight was the LMM, it was 61 basis points, he says. On Wednesday and Thursday, during the worst of the crisis, the average widened to 94 basis points, with Knight at 115, he says. By Friday, with other market makers stepping in, the average had dropped back down to 85 basis points, and Knight was just over that, at 86, he says. ....