Knight Trading Group, Inc.

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Knight Trading Group, Inc.

Newport Tower
525 Washington Boulevard
Jersey City, New Jersey 07310
U.S.A.

Telephone: (201) 222-9400
Toll Free: (800) 544-7508
Web site: http://www.knighttradinggroup.com

Public Company
Incorporated: 1995 as Roundtable Partners LLC
Employees: 933
Sales: $670 million (2003)
Stock Exchanges: NASDAQ
Ticker Symbol: NITE
NAIC: 523120 Securities Brokerage

Based in Jersey City, New Jersey, Knight Trading Group, Inc. is a trade execution specialist, primarily handling stock trading for securities listed on the NASDAQ, OTC Bulletin Board, and Pink Sheets, but also New York Stock Exchange and American Stock Exchange listed securities as well. Knight "makes a market," a function that has been at the heart of stock trading since 1792 when the open auction concept for each stock trade was introduced. Specialists make a market by matching up sellers and buyers at a fixed price, a service for which they receive a commission. Specialists like Knight also step in to buy or sell stocks from their own accounts when there is an imbalance between sellers and buyers. Because of this unique position in the stock market, possessing advance knowledge about the intentions of buyers and sellers, specialists are in a highly advantageous position, one that has been open to abuse. Knight's conduct has come under scrutiny in recent years, leading to National Association of Securities Dealers (NASD) fines for trading violations and Securities and Exchange Commission (SEC) charges that led to a settlement agreement in 2004. In addition to its Equity Markets business segment, Knight also provides asset management services for individuals and institutions. Knight is a public company trading on the NASDAQ.

Cofounder Learning Market Making in the Late 1970s

Although Knight Trading was cofounded by Walter Raquet and Kenneth Pasternak, it was the latter who was the driving force behind the company's growth. In 1976 Pasternak earned an undergraduate degree at the State University of New York, New Paltz, intending to become a teacher. After one semester, however, he realized that he was not cut out for the teaching profession, and went to work with his father in the car trading business. Then, in 1979, he landed a job with the Troster Singer unit of stock specialist Spear, Leeds & Kellogg, which during the 1970s acquired a number of smaller firms, including Troster Singer, to emerge as one of Wall Street's top specialists. Pasternak displayed a knack for trading, as well as a truculent personality, and quickly moved up the ranks, eventually managing the trading room at Troster Singer, where Raquet also worked.

With the rise of discount brokers and online stock purchasing, the securities industry was undergoing significant changes by the early 1990s, leading some, like Pasternak and Raquet, to believe that traditional market makers were losing touch with the times. According to a 1999 company profile in Institutional Investor, the two men got the idea to start Knight "from Lawrence Waterhouse, chairman of discount brokerage firm Waterhouse Securities. 'He worried that he would eventually lose control over the execution quality as the result of brokerage mergers,' recalls Raquet. 'He was too small to support a dedicated market-making operation. But five firms together could provide enough order flow.' " In 1994 Pasternak and Raquet decided to put the idea to the test, founding what was originally called Roundtable Partners. The pair made a simple but effective pitch to convince brokers to take a stake in the venture. By sending their orders to the new market maker for execution, they would be compensated directly for "order flow," and indirectly by their ownership of the firm. Everybody won, especially Pasternak and Raquet. Thus, instead of lining up five partners, they signed up 25 firms, some of which were of the new online variety. These online operators, in the words of Institutional Investor, were "the rocket fuel for Knight's business."

Success for Roundtable was predicated on a large trading volume and the use of the most advanced technology available. To achieve that volume, the firm engaged in what many considered an ethically questionable, albeit legal, practice of paying for order flow. While advantageous to both broker and market maker, such arrangements invariably cost investors money. Keeping costs in line was also of importance, hence the decision to set up shop in Jersey City, where the rents were much lower than on Wall Street. Roundtable then began making online trades and acquiring a number of small specialty brokers to fill out its business. It formed subsidiary Knight Securities to make markets for stocks listed on NASDAQ and the OTC Bulletin Board, and in 1995 acquired Trimark Securities, L.P., which then served as market maker for New York Stock Exchange and American Stock Exchange equities. By the end of the year, Roundtable was only the 88th largest market maker of the NASDAQ, but it was growing quickly.

Aside from shrewd moves, Roundtable was the beneficiary of good timing. According to Business News New Jersey, "The company's start meshed neatly with changes in the way Nasdaq operated. The Securities and Exchange Commission all but shut down a long-time income source for Nasdaq brokers in 1997 when it blocked them from setting artificially wide spreads between the selling and purchase prices of stocks. When that changed, Nasdaq's wholesale business became less fragmented as market makers like Knight stepped into a void the new regulations created."

Going Public in the Late 1990s

The firm got off to such a strong start that in April 1998 it incorporated Knight/Trimark Group Inc. in Delaware, a preliminary step to making a public offering of stock. But even as the company began to pitch its offering, it came under a cloud when it was revealed that Pasternak faced disciplinary action from the SEC from his days at Troster Singer, the result of a SEC probe into the conduct of NASDAQ market makers, charged with colluding to keep spreads artificially wide. All told, 24 firms, including Spear, Leeds, had faced antitrust charges and reached a $1 billion settlement with the Justice Department in 1996. But the SEC continued to look into the matter. Knight had not been a target of the Justice Department investigation, instead benefiting from the situation. Although Pasternak now faced a possible civil penalty and suspension from trading for a failure to adequately supervise the activities of some Troster Singer traders, he was never charged with any violation. Moreover, the suspicion did little to hinder Knight's initial public offering (IPO), which was not met with much institutional excitement but still managed to sell. In July the IPO was completed, raising $145 million, at which point Roundtable Partners became a wholly owned subsidiary of Knight/Trimark Group.

Knight was riding high early in 1999, as the stock market surged and suitors like Goldman Sachs and Lehman Brothers approached Pasternak about selling the firm. Because he insisted on receiving a top post the deals fell through, but he could afford to be demanding, given Knight's strong growth. It was now the NASDAQ's top market maker, a meteoritic rise achieved in just five years. According to a Fortune magazine profile published at the time, Knight "executes some 40% of all online trades and controls almost one-fifth of the trading in Nasdaq/OTC stocks. That's more than Merrill Lynch, Morgan Stanley Dean Witter, Goldman Sachs, and Salomon Smith Barney combined, and almost twice as much as the No. 2 firm. . . . Ranked by volume in U.S. equities, Knight/Trimark is 5½ times bigger than the American Stock Exchange."

By May 1999, when Knight's stock made a 2-for-1 split, Pasternak's stake was worth about $610 million. The little known firm looked to upgrade its image, hiring Omnicom Group's specialist in financial advertising to put together the firm's first national advertising campaign. In addition, Pasternak looked to beef up his executive talent pool to prepare for expansion. He hired John Hewitt, a Goldman Sachs vice-president in the electronic trading group, to become the president of the Knight Securities unit. Hewitt was expected to help the firm become involved in other kinds of securities, including options, as well as to spearhead international expansion. Weeks earlier, Knight announced that it was investing in the Easdaq Stock Market, a wannabe European version of the NASDAQ. In addition, Pasternak harbored dreams of convincing mutual funds, pension plans, and other large institutional investors to trade through Knight. In some respects, however, Knight's ambition was borne out of necessity. Its core business was coming under pressure from new computerized trading technologies, in particular electronic communications networks (ECNs), which had the potential to diminish the need for market makers. ECNs did not buy stocks, but merely coordinated buy and sell orders electronically for a fee. They were more matchmakers than market makers, but they were still very much a threat to Knight's business.

Knight clearly had benefited from a bull market, and as the stock market began to recede, investors questioned whether Knight could sustain revenues under normal trading conditions, since its business model was very much dependent on volume. As soon as the firm failed to maintain its growth rate, investors punished the stock. After reaching a high of $78 in May 1999, it dipped below $25 in October. Moreover, Knight's prospects were dimmed by the upcoming move by the NASDAQ to begin using a decimal pricing system, a change that would tighten the spreads between the price at which Knight bought and sold stocks, resulting in smaller profits.

Company Perspectives:

Knight was founded with an entrepreneurial spirit that is woven into our culture and engenders innovation at every turn. We have a strong corporate culture that's based on firmly held beliefs. We believe that our commitment to the interests of our clients proves our value to them. We believe that marketplace leadership is earned, and not given. We believe that integrity is demonstrated by daily actions and that collaboration is the key to successful, long-term partnerships.

New Name for the 2000s

In 2000 Knight changed its name to Knight Trading Group, Inc. and took a number of steps in an attempt to diversify and secure its independent position, which was further jeopardized by a consolidation trend that saw a number of major Wall Street firms acquiring NASDAQ market makers and taking in house business that might have been directed to Knight. In January it entered the options-trading business by acquiring Arbitrade Holdings, LLC, a little known Minnesota firm that relied on computers to identify trading opportunities. Arbitrade was renamed Knight Financials and business quickly surged, providing the parent company with a welcome source of revenue as NASDAQ trading volumes appeared to have crested. Knight also continued to pursue diversification by applying its model internationally. The firm became a member of the London Stock Exchange, Deutsche Borse, and Euronext Paris, with the goal of becoming a market maker in each. It also established an alliance with Japan's Nikko Securities.

The independent directors on Knight's board and major shareholders, however, were not pleased with the firm's performance, as Knight became a possible takeover candidate because of its low stock price. The board began to pressure Pasternak to step down. In July he made a partial concession, turning over the presidency to Peter Hajas, the head of Knight Financial Products. But Pasternak's position was untenable and by late December he decided to retire, giving up the chairmanship and the CEO post as well, some six months before his contract was set to expire.

Knight settled on Pasternak's replacement in May 2002, hiring Thomas M. Joyce, an experienced trader known for his work ethic and upstanding reputation. A Harvard graduate in economics in 1977, Joyce started out as a stockbroker but did not fare well working with individual investors. It was only after he moved to Merrill Lynch and began doing block trades with other traders that he found his niche, and within four years became the head of the block trading desk. In the mid-1990s he took over the firm's U.S. equities unit, where he was credited with producing record results. When it became apparent that he was not likely to ascend to Merrill's top posts, Joyce in 2001 quit and took a job at Sanford C. Bernstein, where he established a NASDAQ trading department, his last stop before succeeding Pasternak at Knight.

Several months before Joyce took over, in January 2002, the NASD fined Knight $700,000 and ordered the firm to pay $800,000 to clients because of a number of market making and trading violations. One of Joyce's strengths was his clean reputation, but its value to the firm was undermined as Knight faced further investigations into its conduct during the Pasternak years, initiated by a whistleblower, the former head of Knight's institutional trading desk, Robert Stellato. He accused Knight of engaging in "front running," a practice in which the firm used knowledge of client orders to buy or sell stock before placing the client's order. The Wall Street Journal offered an example: "If an investor wanted to buy, say, 1,000 shares of Intel Corp., that person would call their stockbroker, who would arrange to have Knight place the order. But before doing that, Knight's trader allegedly would at times buy Intel stock for his own Knight account, presumably getting in at a cheaper level than what the price would be when the customer order was finally filled. In some cases, the trader's buying could even drive up the stock price, making it yet more expensive for the customer who placed the order in the first place."

Despite the legal distractions, Joyce took steps to turn around Knight. In 2002 Knight lost $43.2 million on revenues of $527.4 million, but a year later sales improved to $670 million and the firm returned to the black, posting net income of $38.5 million. To reorganize the firm, he added to Knight's ability to serve institutional customers by acquiring Atlanta-based Donaldson & Company, which provided research and other services. He also closed down Knight's American Stock Exchange equity options desk, then in 2004 sold the firm's derivatives business to Citigroup Inc. for approximately $225 million. Not only did this business provide a low return, it was capital-intensive, so that its sale allowed Knight to focus more resources on its remaining business segments, Equity Markets and Asset Management.

In 2004 Knight began to come out from under the cloud of litigation when it reached a settlement with the SEC and NASD, agreeing to pay $79 million in penalties, interests, and trading profits. A whistleblower suit also was settled in 2004 when a NASD-overseen arbitration panel ruled against Stellato, who had maintained that he had been wrongfully fired because he exposed Knight's trading practice. The firm's counterclaims also were dismissed. With the legal issues now behind the firm, Joyce could fully concentrate on growing Knight, which continued to face challenges in a highly competitive and changing marketplace.