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From Knight into day

Direct Edge: Tech controls may have prevented $440M disaster of its ex-owner

From left, Saro Jahani, Bryan Harkins and William O'Brien, all of Direct Edge, which used to be owned by Knight Capital. Direct Edge says military precision and regulatory oversight of trading can prevent the kind of bailout needed to rescue Knight earlier this month.-(Aaron Houston)

Jersey City-based Direct Edge has grown in just a few years into the nation’s fourth-largest stock exchange, one of the new breed of electronic securities trading venues that are shaking up Wall Street.

Jersey City-based Direct Edge has grown in just a few years into the nation’s fourth-largest stock exchange, one of the new breed of electronic securities trading venues that are shaking up Wall Street.

Now, CEO William O’Brien is trying to wake up Wall Street to the need he sees for stronger regulatory oversight of stock trading, in order to restore investor confidence following a string of troubling stock trading glitches. The latest, on Aug. 1, cost Jersey City brokerage Knight Capital Group about $440 million, forcing it to obtain a $400 million bailout from a consortium of Wall Street firms. Knight is the former owner of Direct Edge; it currently has a nearly 20 percent stake in the exchange.

O’Brien said a stronger role for the U.S. Securities and Exchange Commission “will help inspire confidence. The average investor should know that people are working very hard to give them complete confidence that when they press that button, they are going to get a reasonable and rational result every time.”

Saro Jahani, chief infor- mation officer of Direct Edge, is an electrical engineer with 25 years in computer network- ing who joined Direct Edge in 2011. He created a so-called “sandbox” —a kind of simula- tor where new software is test-driven before it goes live — for Direct Edge, and said investors needn’t fear rogue computers running amok on Wall Street. “In reality, computers are doing what they are told to do. You have to control the process. My job is to create stable operations. We apply military precision here; that is my job,” said Jahani, who in the 1990s worked with fullscale copies of Sweden’s nuclear power plants.

Since O’Brien arrived more than five years ago, Direct Edge has grown from 19 employees to more than 130 today, and its market share has grown from about 1 percent of U.S. securities trading volume to about 10. Additionally, it handles more than 600 million shares of daily trading volume. As a private company, Direct Edge doesn’t report revenue or profits, but said it has been profitable since the fourth quarter of 2007.

Direct Edge is ranked only behind the New York Stock Exchange, Nasdaq and third-ranked BATS, an upstart exchange launched in 2008.

“We’re very proud to have done our part to make New Jersey the new Wall Street,” O’Brien said.

The company is looking beyond New Jersey, too: In a major bid to move into the global arena, Direct Edge is seeking permission from Brazil to open a new stock ex- change in Rio de Janeiro to compete with the Sao Paulo exchange.

Founded in 1998 as Attain ECN, the company was purchased in 2005 by Knight Capital, which rebranded it as Direct Edge and spun it off in 2007 as an independent company now owned by a consortium including Knight, Citadel and Goldman Sachs. Direct Edge then secured SEC approval to become a stock exchange and, in July 2010, went live with two exchanges, EDGA and EDGX, which offer brokers and other stock traders a choice of pricing structure and trade execution. An advantage of becoming an exchange is that exchanges maintain public quotes derived by the Securities Information Processor, a continuous stream of real-time best bids, offers and last sales that traders pay for, with the exchanges splitting the profits.

Justin Schack, managing director, market structure analysis for Rosenblatt Securities, credits Direct Edge with being “a disruptive force in the U.S. exchange industry. They have used a semi-mutual ownership structure, pricing competition and some innovative market structure wrinkles to take some pretty significant market share from incumbent exchanges like NYSE and Nasdaq.”

Schack said both Direct Edge and BATS were launched by large brokerage firms and proprietary trading firms seeking a competitive alternative to NYSE and Nasdaq. He noted that stock exchanges have historically been owned by member brokerage firms, and operated for their benefit. A key innovation by Direct Edge, Schack said, was launching two exchanges side by side to address different segments of the securities trading marketplace.

Bryan Harkins, chief operating officer, said Direct Edge “became a place where traders and brokers could lower their fees and take advantage of new product offerings. Just like any other business, the trading of stocks should be subject to competitive pressures.”

Direct Edge is not immune to the businesses challenges facing all stock exchanges. Investors don’t have to trade their securities over an exchange, and it’s estimated that more than 30 percent of all trades occur in off-exchange trading platforms.

The technology that powers Direct Edge is housed in a data center in Secaucus; the company intends to relocate a backup facility in Clifton to the Chicago area in 2013, so Direct Edge won’t be vulnerable if a disaster strikes the metropolitan area.

Stock trading glitches are getting more attention, but Rutgers University economics professor Bruce Mizrach said a research paper he co-authored with graduate student Cheng Gao shows that market breakdowns were as common in 1997 as in 2010.

Mizrach said it’s significant that the SEC forced Knight Capital to suffer the losses from its technology glitch, rather than being allowed to reverse the errant trades. Mizrach said the securities industry needs an incentive to carefully manage technology and, “if we’re not going to force them to eat the losses, then that’s never going to happen.”

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Beth Fitzgerald

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