What Should Have Happened to Knight

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When people go to gamble, say in Las Vegas or Atlantic City, they arrive with high hopes and a false sense of caution. With a bit of skill, a dose of luck, and one too many vodka tonics, it seems possible to beat the house. Well, if this was ever you, you know the end of the story -- you come away with less dignity than a Paris Hilton DJ show and with a much thinner wallet. For a lot of us, this is the learning curve. We realize at that point, "This probably isn't the game I want to play," and from then on trips to Vegas consist of pool parties and maybe a quick walk through the slots. If you go back to the tables, you deserve the ensuing bankruptcy. This theory applies to the gambling man, but it should apply to the gambling Wall Street firm as well.

How to lose money incredibly fast
Have you ever lost $440 million in less than an hour? Me, too. Now, to be fair, it wasn't all Knight Capital's (NYS: KCG) fault. On that dreadful money-evaporating day, the New York Stock Exchange (NYS: NYX) also launched its new Retail Liquidity Platform, aimed at taking back some of the trading volume siphoned by firms such as... Knight Capital. Glitches and various technical hoopla caused Knight to almost go night-night.

Luckily for them, Goldman Sachs (NYS: GS) threw the company a $400 million bone, and Knight continues to make markets and play the role of "house" day in and day out.


Good for the goose, terrible for the gander
What is good for Knight is doing the market at large a disservice. For once, a market player like Knight needs to experience what the retail investor and the gambler experience -- a true loss. That way, and only that way, will incentives align on Wall Street to clean things up. If you have been following the financial news at all for the last 200 years, you could see the pattern that big money and regulation are in an eternal game of one-upmanship. Regulations come into play, the corporations find a way around it, regulators reregulate, so on and so forth.

Knight is not the most evil firm on the Street, and who am I to judge...? This isn't a witch hunt; it's just a call for justice. If I screw up and my gin-soaked human brain dumps my equivalent of $440 million in 45 minutes, I lose that money and no one is going to come give me a tissue. It's the same result if I go back to the tables feeling lucky.

Knight's shareholders were highly diluted after the incident but Knight should have gone under. Not because it's a fundamentally bad company, not because management makes too much money, not even because the company basically plays both ends of the stick and profits no matter what -- Knight should have gone under because that's what it takes to wake people up. Maybe the high-frequency trading firms would have said, "Oh, we can lose," instead of, "Well they screwed up, but we all make mistakes." You don't hear that leaving the Las Vegas airport.

Tough love
UBS
(NYS: UBS) wants its money back from the Facebook IPO disaster. The securities giant is suing Nasdaq for the $365 million it lost. I'm sorry, UBS, but this is how the thousands of retail investors who bought in on the IPO feel, too. Except they don't have the luxury of billion-dollar law firms at their disposal.

UBS needs to feel this loss, even though it's not enough to really shake things up. Once these firms start feeling the pain, then we will see some real change on the Street. In the rare event that Washington finds a way to accomplish something, don't expect the clouds to clear -- they will just rearrange into new formations that still rain down on Main Street every trading day of the year.

This is a dour editorial, and I don't think investing in equities is the same as blackjack. Those who follow the Foolish way of investing in the long term in quality companies will circumvent the market as a whole because even it cannot keep quality businesses from doing what they do best. But if you come up to your computer tomorrow morning thinking, "What am I going to do in the market today?" be careful. I hear there is a 100% chance of rain.

For a primer in long-term, Peter Lynch investing, check out the free report on three stocks Wall Street is too rich to notice. Your revenge can be your returns.

The article What Should Have Happened to Knight originally appeared on Fool.com.

Fool contributor Michael Lewis owns none of the stocks mentioned above. You can follow him on Twitter @MikeyLewy. Motley Fool newsletter services have recommended buying shares of NYSE Euronext and Goldman Sachs Group. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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