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Will Knight Capital's Trading Disaster Hurt Market Confidence?

If history is a guide, confidence in market structure will take another hit following Knight Capital's $400 million trading software glitch.

It's been less than a week since Knight Capital's new trading software went berserk and nearly destroyed the company. In the days following the incident, reactions have been swift and harsh, with some pundits calling for more oversight with others continuing to insist that the market will sort this out by itself.

However, even the most steadfast electronic market structure supporters are beginning to waiver after the latest event, which cost Knight Capital $400 million and left it scrambling to raise capital.

[For more initial "snap" reactions to the Knight Capital trading incident, read Knight Capital Sets Twittersphere Afire, Just After #Knight Burns Itself.]

No doubt, confidence in the market has taken a hit, just as it did following the Facebook IPO mess, the BATS incident and, of course, the Flash Crash in 2010. In order to gauge the current sentiment among market participants following the Knight Capital event, Tabb Group is launching another study.

After previous market incidents, according to a Tabb Group survey fielded shortly following the Facebook IPO, investor confidence fell due to the technological glitches in the equities markets. The drop in confidence was clearly seen following the Flash Crash and the blundered Facebook IPO, according to Adam Sussman, a partner and director of research at Tabb Group, a New York-based a financial markets' research and strategic advisory firm.

"Following the Flash Crash and the IPO fiasco, [Knight] is another illustration of the flaws in the US equity market structure," Sussman says. "It's not that a lot of investors outside of Knight were damaged. But the incident does more damage to US equities as a brand. This incident, on top of the previous ones, chips away at the US exchange-traded markets as a safe place to trade."

Following the Facebook IPO, Tabb Group's "IPO Survey: Market Barometer" found that the impact of Facebook's IPO on investor confidence was almost as great as the Flash Crash. In addition, the survey found that 31 percent of participants said their confidence level in the US equity markets was weak or very weak and that the confidence level of respondents was lower than a similar survey TABB conducted in the wake of May 6 Flash Crash.

"This might be a tipping point where even the most ardent believers in current market structure have been convinced the market needs some additional protections," Sussman says. "Whether there are new regulations or some form of market integrity rule," as SEC Chairman Mary Schapiro suggested last week, "a fair number of people think something must be done."

In fact Sussman, a frequent commentator on market structure issues, may have also shifted his position on what needs to be done to make sure the equities markets are sound. Previously, Sussman commonly took the position that the competitive, electronic US markets were in good shape and didn't need excessive changes or additional -- often burdensome -- regulation.

"What has changed since knight, is that previously I have been a defender, an apologist, for market structure," admits Sussman. "Now, for a lack of a better word, I feel let down about the recent events. These problems are more and more frequent. There needs to be an effort on the part of the industry and that is no small task. It is not necessarily a role of regulators because they do not have the tools to do it."

Whatever happens, something needs to be done, Sussman contends, especially because the survey results show a continued weakening of market confidence. Following the Flash Crash in 2010, 53 percent of survey respondents stated their confidence in the US markets was very high, or high. In 2012, following Facebook's IPO, the number dropped to 36 percent.

"Overall, I don't think Knight is not going to be as big an issue as the Flash Cash or Facebook," Sussman says. "But I do expect to see a continued drop in confidence."

To participate in the most recent Tabb Group Market Structure Confidence survey, click here. Greg MacSweeney is editorial director of InformationWeek Financial Services, whose brands include Wall Street & Technology, Bank Systems & Technology, Advanced Trading, and Insurance & Technology. View Full Bio

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