Knight Capital Being Saved By Very People It Tried to Screw Over

Either way, there's one developing storyline in the saga of Knight Capital Group Inc. (NYSE: KCG), the Wall Street market maker that lost more than $440 million Wednesday when an automated trading program it had just installed went berserk, that's not being talked about: The firm is being propped up at the moment by the very people it tried to screw over.

Some context: After Knight Capital's rogue algorithm was unleashed upon the world to pursue 45 minutes of $10-million-per-minute capital destruction -- which was made obvious by the fact that more than 100 New York Stock Exchange issues suddenly saw insane trading volume and price swings -- the company's chairman and CEO went on Bloomberg Television to excuse the event by saying, "Technology fails."

Of course, Thomas Joyce added, "We need to do a better job in our testing environment."

To the unaware, Joyce's words suggested Knight was just the unfortunate victim of a standard software upgrade gone horribly wrong. As such, they probably resonated at an emotional level, bringing back memories of the time the email server inexplicably forwarded a borderline inappropriate joke email to the entire office or the new Skype plug-in wiped out three years' worth of email messages.

But there was nothing standard about the software upgrade Knight was doing.

Knight's program, had it worked as intended, was supposed to take advantage of a new trading platform introduced by the NYSE Wednesday called the Retail Liquidity Price, or RLP, program. The RLP program, basically an exchange within the larger exchange, was designed by NYSE to give smaller traders a chance to gain the same edge as larger traders who often get a better deal by trading through peer-to-peer "dark pool" exchanges.

When the NYSE first announced it was building the RLP program, the big players, including Knight, loudly complained, telling the U.S. Securities and Exchange Commission the new system would disrupt trading by dismantling a ban on quote increments of less than 1 cent. Firms such as the privately held Citadel LLC, Citigroup Inc. (NYSE: C), Invesco Ltd. (NYSE: IVZ), and UBS AG (NYSE: UBS) also joined the whining.

But the criticism was little more than a thinly veiled attempt by these market participants to get the SEC to defend their market edge.

Knight is one of the operators that sometimes routes client orders to internal "dark pools." Once the RLP program was launched, Knight and its peers would face competition in the lucrative business of routing clients to those trading platforms. After the SEC gave the RLP program the thumbs-up, Knight's defiant CEO admitted on a client conference call that the new program was an "instrument crafted by our friends at [the NYSE] in an attempt to garner more retail market share" away from companies like Knight. 

Knight clearly took the NYSE's initiative as a direct challenge, with Joyce saying, "Let the games begin," according to Bloomberg News.

Knight quickly delivered on its saber-rattling. Taking the if-you-can't-beat-them-then-scalp-the-bejeezus-out-of-them approach, the firm contracted a third party to build an automated trading program that would make sure it could dominate this newly created corner of the NYSE from Day One, thus defeating the stated purpose of the RLP program.

Despite losing $440 million, Knight can still claim it seemed like a good idea at the time.

But here's the kicker: Once it was obvious Knight was in trouble Thursday, the big players on Wall Street turned their backs on the company, maybe in the belief that it's not safe to swim near a drowning man or perhaps because they all figured they could fight over the firm's spoils if it went under.

Prime brokers Sterne, Agee & Leach Inc. and Concept Capital Markets LLC, mutual-fund giant Vanguard Group Inc., and asset manager Fidelity Investments sent out notices to their clients that they were no longer doing business with Knight. Citigroup was rumored to be giving Knight the silent treatment. Virtu Financial, a competitor that was said to have been approached by Knight to negotiate an emergency merger, reportedly turned the firm away, figuring it could do better by purchasing Knight's assets at a fire sale after the firm went under, even if a few thousand people lost their jobs as a result.

A consortium of banks, including the Bank of America Corp. (NYSE: BAC), Bank of Montreal (NYSE: BMO), JPMorgan Chase and Co. (NYSE: JPM), and U.S. Bancorp (NYSE: USB), did negotiate a $200 million credit line with Knight. But the terms were incredibly stingy, essentially requiring the banks to make a life-or-death decision on Knight every business day. And if history is any guide -- cough, MF Global, cough -- the loan probably includes insanely attractive profit incentives for the banks should Knight go under.

The only people to actually step up to help Knight in its moment of need, it appears, were the small guys. After temporarily halting activity with the firm Thursday, both TD Ameritrade Holding Corp. (NYSE: AMTD) and Scottrade Inc. said Friday they were once again beginning to route orders through Knight. Ditto Trade, an even smaller retail brokerage, said the same. These firms are small potatoes compared with institutions such as the Goldman Sachs Group Inc. and JPMorgan, serving mostly small investors, 401(k) account holders, and the endangered Wall Street species known as the bedroom day trader.

Of course, cynics might argue words of loyalty and relationships are hogwash, and that those brokers would be jumping ship alongside everyone else if they had the power to do so.

But the fact still stands for the moment: In Knight's time of need, the very people it was counting on screwing over as part of its business model could be counted on to give it a helping hand.