June 10, 2002
Knight Trading Group, at times Nasdaq’s biggest trader, is under fire. The Securities and Exchange Commission and NASD Regulation reportedly are looking into allegations of improper trading practices that threaten to expose the inner workings of this controversial broker-dealer.
Investors know Knight as an active market maker with a low public profile. But anonymity aside, Knight has been a major player on Wall Street in recent years. The firm matches buyers and sellers of securities, for a fee. Just two years ago, the firm handled over 11% of all buy and sell orders for Nasdaq-listed stocks during the dot com boom. Back then, Knight’s own stock was flying high, rising to $78 a share in 1999. Now, it trades at around $6.
Knight also has been among the most active traders of OTC Bulletin Board stocks, dominating the market, and the price, for some of those thinly traded securities.
Market makers like Knight, who process tens of thousands of transactions for other brokerage firms, pose a particular problem for investors who want to know which firms are dominating the market for a stock. These market makers afford a degree of anonymity to those other broker-dealers. When investors notice unusual volume in a security they can find out the identity of the principal market makers, but that is only one part of the story. Which brokerage firms are placing most of the orders? Where is the glut of stock coming from? With Knight as the “front-man” for those trades, the public investor remains in the dark.
Knight may be in for some more rough days, thanks to the former head of its institutional trading desk, Robert Stellato. According to a report in the Wall Street Journal, Stellato filed a complaint with the NASD charging the firm with various rules violations. The complaint included allegations of “front-running” – charges that Knight traders executed orders for their own account before filling customer orders.
Investors have little direct contact with Knight, even though the firm may be a material party to the customer’s transaction. When a customer wants to buy or sell stock, he or she calls a broker, who in turn places the order with Knight. Front running occurs when the Knight trader buys the same stock for his or her account, before executing the customer’s trade, and at a better price than the customer gets.
That front running can affect the stock price. As a result, the customer may wind up paying more to buy a stock, or getting less on a sale.
Stellato’s claim purportedly charges that he was informed that Knight executives had been front-running customers in concert with traders and with the knowledge of Knight’s CEO Kenneth Pasternak. Stellato claims that he confronted Pasternak and the firm’s legal counsel, Mike Dorsey, with these allegations, but was rebuffed by Dorsey, who told him that he did not see evidence of front running.
According to the Wall Street Journal report, Knight has denied Stellato’s claims, but the complaints go to the root of Knight’s business. If the firm has been diverting profits from investors, its future credibility could be irreparably repaired. And those investors may soon line up to file claims.
Knight has acknowledged that the SEC is investigating these charges.
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