Market makers buck trend as profits surge

Market-making firms bucked the trend of poor results for trading groups, though the results are unlikely to be sustainable.

Knight Capital reported net income in the quarter was $40m, almost four times the $9m profit in the same quarter last year, principally on stronger revenues in its market-making unit, which matches stock trades primarily for retail brokerages.

The increase came despite weak volumes, which has been the cause of poor results across Wall Street. However, Knight was able to profit from elevated volatility by providing matches for traders who would otherwise not find them in the public markets.

“Knight may have been a bit of an outlier because of its relatively unique focus on equities market making,” said Patrick O’Shaughnessy, analyst at Raymond James.

Interactive Brokers, the retail brokerage and market-making firm, also reported a sharp increase in its market-making revenues despite a 37 per cent drop in volume. Sales were $166m in the quarter, up from $44m a year ago, though that included some gains from currency translation. Profits in the unit swung to a gain of $92m, versus a $23m loss a year ago.

Knight uses a combination of human brokers and computer algorithms to handle trades sent to it from retail brokers such as TD Ameritrade, which differs from the primarily institutional business of big banks.

Thomas Joyce, chief executive, attributed Knight’s results to the shift in trading by retail toward defensive blue-chip stocks that are higher priced, which allowed Knight to take larger profits per trade.

“The composition of the order flow was heavier on high-priced stocks. As a result, average price per share traded more than doubled, which factors into revenue capture,” Mr Joyce said.

Knight’s revenue capture jumped to 1.4 basis points per trade, well above Wall Street estimates and even its own guidance of as much as 1.2bp.

Interactive Brokers, which sources flow from its own brokerage business, said its increase “reflected trading gains on higher actual-to-implied volatility, higher options trading volumes and wider bid-offer spreads”.

Knight’s shares surged 9.4 per cent following the results, to $12.96. Knight had tumbled sharply last summer, as it announced lay-offs – its headcount fell 7 per cent in the quarter – and warned of poor performance amid low market volumes.

“Knight’s conservatism may be causing some investors to have an unwarranted lack of confidence in the sustainability of the model,” said Richard Repetto, analyst at Sandler O’Neill.

Shares of Interactive Brokers, which reported its results after the closing bell, were up 0.4 per cent to $15.27.

However, Knight’s Mr Joyce warned analysts that the group’s performance was not necessarily indicative of a fundamental improvement in margin, and may not be replicated in future quarters.

“It was not by design; it was more random. We can’t really dictate the quality of the flows as such, of course,” he said.

Analysts at Goldman Sachs earlier this week downgraded Knight from “buy” to “neutral”, citing increased competition, which may only be accelerated by market-makers’ strong performance amid an otherwise dismal quarter for trading groups.

Daniel Harris, Goldman’s analyst, argued that while Knight was attractive at low share prices resulting from a year of muted market volumes, it was facing increased competition in market-making by groups such as Credit Suisse and Cantor Fitzgerald. Goldman’s own trading division, separate from its investment bank, is entering the business as well.

Knight also said that it continued to make lay-offs in its institutional trading group, cutting headcount by 7 per cent in the quarter.

Results for that business line were weaker at $104m, down 8 per cent from the same quarter a year ago, in contrast to the 69 per cent growth in market-making revenues to $187m.