[A longer version of this story originally appeared on our sister website, IndexUniverse.com]

Knight Capital (NYSE: KCG), the biggest ETF market maker in the US, is getting a US$400 million lifeline in the form of a convertible preferred stock sale to several buyers, but the deal still needs a regulatory rubberstamp before it’s official.

While the sale would allow Knight to stay in business, it would also heavily dilute existing shareholders. The new investors are being offered convertible securities to buy Knight stock at US$1.50 a share, according to an 8-k filing submitted by the company to US regulators. Knight’s shares closed on Friday at US$4.05, but were already trading some 28 percent lower, around US$2.90, in early US trading on Monday.

The preferred securities being sold would eventually convert into some 267 million shares of common stocks of the trading firm. Jefferies & Co., Getco, General Atlantic, Blackstone Group, TD Ameritrade, Stephens Inc. and Stifel Nicolaus are all said to be buyers, according to media reports.

Knight was forced into an emergency financing round after a trading glitch involving its systems on Wednesday affected 148 stocks, resulting in a US$440 million pre-tax loss.

“The company is actively pursuing its strategic and financing alternatives to strengthen its capital base,” Knight said on Thursday in a press release, stressing that it will be business as usual for the company in the wake of the wayward trading episode. The company has yet to make any other public statements.

The swiftly moving story is one of the more astonishing developments in the world of electronic securities trading, where Knight plays a leading role. The episode was centred on individual stocks, but affected some exchange-traded funds as well, notably the Vanguard Utilities ETF (NYSEArca: VPU), which traded well above its net asset value during the time the rogue trades took place, between 9.30 am and 10.15 am New York time on Wednesday.

The drama took a turn for the worse for Knight as Thursday’s trading session unfolded amid reports that several counterparties had stopped trading with the firm.  For example, Vanguard, the second-largest US ETF sponsor by assets, told the financial television network CNBC that it was routing ETF-related trade away from Knight.

“For Knight, it’s pretty dire,” Scott Freeze of Street One Financial, said in a telephone interview.

“There seems to be a big concern about them being able to sustain themselves,” Freeze added.

The point was driven home by a debt downgrade from Egan-Jones Ratings, which cut Knight’s credit rating to “CCC” after having cut it to “B-” earlier in the day. The ratings agency described Knight’s capital loss as “debilitating,” according to a Reuters report.

There was even talk about a possible bankruptcy filing, according to several media outlets, including the Wall Street Journal.

For the record, Knight said in the press release that while the whole episode “severely impacted” its capital base, its broker-dealer units remained in compliance with net capital requirements.

Sharks Circling

After the trading loss, industry sources predicted that Knight could attract interest from a number of buyers, particularly those interested in gaining a foothold in ETF trading.

“Whoever has been dying to get into this business must be whetting their lips right now,” said one industry source, who spoke to IndexUniverse on condition of anonymity.

But buyer interest may be selective, the source continued.

“If you’re looking to beef up your ETF business, you don’t want to buy all of Knight,” he said.

While Knight’s capacity to provide deep markets in stocks and ETFs may be temporarily compromised because of the hit it has taken, the whole episode is likely to blow over sooner rather than later, says one ETF market observer.

“If this has any effect on ETFs, it’s not likely to last very long,” Richard Keary, head of New York-based Global ETF Advisors LLC said in a telephone interview. Keary’s firm advises clients that are interested in bringing new ETFs to market.

ETFs Caught Up In The Weirdness

Nonetheless, Wednesday’s episode affected a few ETFs, such as Vanguard’s VPU--apparently because one of its constituents, Excelon Corp. (NYSE: EXC), was caught up in the unhinged trading. EXC shot up Wednesday morning, and, it seems, took VPU up with it. The ETF's NAV was around US$81 a share, but a number of trades were well above that price—some at more than US$84.92 a share.

The Market Vectors Gold Miners ETF (NYSEArca: GDX) is another ETF that became untethered from its NAV during the episode, falling sharply during the episode.

Neither VPU nor GDX were on NYSE’s list of securities the exchange said it was reviewing, but EXC, the utility company, was.

So, while the unhinged algorithm at Knight doesn’t appear to have been explicitly linked to particular ETFs, Knight’s problems did affect some ETFs. Knight is the lead market maker on as many as 350 ETFs listed in the US.

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