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October 4, 2007

Knight’s IOIs Keep Orders Dark

By Nina Mehta

One of the biggest trading houses is stepping up efforts to bypass exchanges and ECNs when laying off positions from its vast market-making operation.

Knight Equity Markets, the broker-dealer subsidiary of Knight Capital Markets, the big institutional and wholesaling firm, is executing more than 60 million of its 400 million shares per day through Knight Link, an electronic indications-of-interest service. The customers using the service include the electronic trading desks of 10 to 15 bulge bracket brokers.

Volume in Knight Link, which launched in mid-2006, ramped up this summer. In August, when volumes took off everywhere, the system executed 66 million shares per day, said Jamil Nazarali, head of electronic trading at Knight Equity Markets. In July it executed a daily average of 50 million shares, and in June an average of 33 million. Overall, the firm executes 400 million shares per day in listed and Nasdaq stocks.

Knight Link's flow is generated by Knight's executions against its retail broker-dealer clients, including E*Trade, Fidelity, Scottrade and Ameritrade. After Knight executes client orders, it typically seeks to lay off its position and manage its risk.

Knight Link sends streaming IOIs from Knight's electronic trading desk directly to the routing engines of big brokers. If a broker has an order on the other side, it can send the order to Knight, which then executes the trade and reports it to the NASD/Nasdaq trade reporting facility. Knight Link also accepts immediate-or-cancel orders from some clients, instead of sending them IOIs. Nazarali says Knight Link's fill rate is "over 90 percent" for the streaming IOIs, which represent about 75 percent of Knight Link's executions.

Knight doesn't charge brokers for Knight Link executions. According to Nazarali, the system's main competitors are dark pools, which try to attract broker flow before it's sent to the market. Knight Link's IOIs, often for several thousand names-because of Knight's huge market-making business-include the firm's side and size for every name.

This IOI product is different from the traditional indications for natural contra-side liquidity that many brokers send to traders. This type of IOI from electronic market makers and dark pools is directed to algorithmic trading or electronic routing engines, not humans. The human traders are never aware of the IOIs until after a trade occurs.

Knight isn't the only market-making firm providing this type of service. Other large electronic liquidity providers such as Automated Trading Desk, which Citi bought in June for $680 million, stream IOIs directly to the electronic trading engines at many big brokers. Goldman Sachs' Sigma X pool, for example, gets streaming orders from about half a dozen electronic liquidity providers, including Knight Link, ATD, Liquidnet H2O and NYFIX Millennium.

Several large brokers contacted by Traders Magazine said they use Knight Link as well as similar indications-type products from other firms. These are considered additional sources of liquidity for the brokers after they internalize what they can within their own walls. All said their customers can choose to opt out of executing against this flow.

JPMorgan's Carl Carrie, global head of algorithmic products in the broker's electronic client solutions group, said his firm connects to Knight "in a variety of ways" and also connects to "a number of IOI-related products." He added that there now exists "a virtual book of IOIs for algorithms to trade against."

For brokers, an execution in Knight Link "reduces market-impact costs and avoids exchange or ECN fees," Nazarali said. For Knight, avoiding the public markets reduces its fees, facilitates its risk management and enables the firm to take on more trading with clients because it can more easily hedge its activities.

Nazarali said the next stage for Knight Link is working with ECNs, exchanges, mid-tier and regional brokers, and order management systems and execution management systems to provide them with an additional liquidity source that can potentially reduce their execution costs.