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Deutsche Bank bid for NDB nabs market-making unit

The deal-sweetener behind Deutsche Bank's $1 billion offer to acquire National Discount Brokers may be NDB's highly profitable behind-the-scenes market-making unit.

The deal-sweetener behind Deutsche Bank's $1 billion offer to acquire National Discount Brokers may be NDB's highly profitable behind-the-scenes market-making unit.

And that gives investors hope that other large financial powerhouses may woo Knight Trading, the only remaining independent, top-tier market maker.

Tuesday's offer by Deutsche Bank highlights the growing trend among large institutions to operate internal market-making units because the business has been so profitable.

This year alone Merrill Lynch acquired Herzog Heine Geduld, and Goldman Sachs acquired Spear Leeds & Kellogg. Charles Schwab, the largest online broker, acquired Mayer & Schweitzer last year.

"Returns on capital in the market-making business are attractive," Matthew Vetto, an analyst at Salomon Smith Barney, wrote in a report Tuesday. "And to the extent broker/dealers can find a way to capitalize on the order flow they are already generating, all the better."

Market makers are individual dealers that openly compete with one another for investors' buy and sell orders. All brokerage firms, online and offline, route their trades through a finite number of market makers, with the top firms receiving the bulk of the business.

For the larger market makers, business exploded during the past couple of years, when the stock market ran its bullish course. NDB's market-making unit, NDB Capital Markets, accounts for between 60 percent to 70 percent of the company's overall revenues, according to analysts. Financial institutions that run market makers route not only their own trades through these units but also the trades of brokers that don't have their own market makers.

"There is tremendous value to the market-making platform," said Tim Butler, an analyst at Pacific Crest. "Deutsche Bank further validated that."

Knight is the largest Nasdaq market maker and the third overall listed market maker. More importantly, perhaps, is that it is the only market maker in the top 10 that remains independent of a broker or dealer.

Knight "is a logical take-out play," said Butler, putting the company's value at just over $50 per share based on extrapolating the value from Tuesday's proposed deal.

But Salomon Smith Barney's Vetto said estimating the valuation implied in the deal, the value of Knight is around $25 per share--even lower than what it was trading for Tuesday.

Knight's shares budged only slightly higher, rising 56 cents, or about 2 percent, to $25.63 in afternoon trading Tuesday. However, it's a "premier property whose scarcity value is increasing by the day," Vetto said.

A windfall for online brokers
The Deutsche Bank offer had a pronounced effect on the stocks of online brokerages, lifting many companies in the sector. The online trading industry has been mired in a gloomy outlook because the persistently looming bearish market could lead to fewer trades being placed by individual investors.

Knight recently warned that earnings would fall below expectations because the number of trades placed had declined recently.

On Tuesday, shares of Ameritrade surged higher on the NDB offer, climbing 81 cents, or 5.75 percent, to $14.94 in the afternoon. E*Trade saw it shares rise 31 cents, or about 2 percent, to $14.38

While Deutsche Bank's main interest in paying a pretty premium for NDB may be to acquire a market maker, most online brokers lack a similar attractive asset.

Still, online trading services are increasingly considered an integral part of the services a banking institution must offer to have one-stop financial services, from banking to online trading, financial advice, insurance and lending services.

"What we're seeing is the converge scene playing out," Butler said. "Deutsche Bank wants to come in and add to its financial services by one, adding an online broker, and two, getting a market maker."

Vetto added that the Deutsche Bank deal "would represent the first step in consolidation among the top 10 online brokers."