The average spread between bid and offer prices for some lightly traded U.S. exchange-traded funds widened yesterday as Knight Capital Group Inc. (KCG:US), the biggest market maker for ETFs, struggled to survive.
Spreads on low-liquidity ETFs for which Knight is the lead market maker on the New York Stock Exchange rose to 1.53 percent yesterday, according to data compiled by research firm IndexUniverse LLC. The spread averaged 0.49 percent before Aug. 1, when a computer glitch at Knight caused losses nearly four times the firm’s profit last year.
Knight Capital handled the largest share of ETF trades in the first quarter of 2012 with 17 percent, according to the firm’s website. The firm, based in Jersey City, New Jersey, is in contact with creditors, clients and counterparties after a “fairly major” software bug caused trading errors costing it $440 million, Chief Executive Officer Thomas Joyce said yesterday on Bloomberg Television’s “Market Makers” with Erik Schatzker and Stephanie Ruhle.
“ETFs are dependent on third parties” to make markets, Paul Justice, head of ETF research in North America at Morningstar Inc. (MORN:US), said in a telephone interview. Should the firm fail, “There would probably be a temporary gap in liquidity until someone else steps in with that volume.”
Kara Fitzsimmons, a spokeswoman at Knight Capital, didn’t immediately return phone calls and e-mails seeking comment.
Knight Capital opened its books to potential buyers, including private-equity firms and at least one securities- industry rival, said two people with knowledge of the matter.
Knight is working with Goldman Sachs Group Inc. and Sandler O’Neill & Partners LP as advisers in the rescue talks, said one of the people, who spoke on condition of anonymity because the discussions are private. The company is under pressure to strike a deal within days, the people said.
All U.S. ETFs have at least two market makers and the field is competitive, according to David Nadig, director of research at San Francisco-based ETF IndexUniverse.
“Even in the worst-case scenario, there’s an awful lot of quality competition that will be more than willing to jump in and pick up the slack,” Nadig said.
Market makers also play a key role in keeping ETFs priced in line with the value of their underlying assets. When those values diverge, market makers create or redeem shares in large blocks, moving fund share prices back in line with assets.
“Providers are concerned because it’s our job, but I don’t think investors should be worried,” Scott Ebner, head of ETF product development at Boston-based State Street Corp. (STT:US), the second-biggest biggest provider of ETFs worldwide. “The competitive process is what drives efficiency in the market, not a single participant.”
Knight Capital is the lead market maker for 54 State Street U.S.-registered ETFs, or about half the U.S. total. Replacing a lead market maker wouldn’t be difficult, Ebner said
Reginald Browne, who joined Knight Capital along with a team of managers and traders from Newedge USA LLC in 2009, leads the firm’s ETF trading group.
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