Knight Capital (NYSE: KCG), the biggest ETF market maker in the U.S., is getting a $400 million lifeline in the form of a convertible preferred stock sale to several buyers in a deal that would keep the troubled trading firm in business.

While the sale spares Knight from having to consider bankruptcy following last week's trading debacle, it also dilutes the company as it lets investors holding these convertible securities to buy Knight stock at $1.50 a share, according to an 8-k filing the company submitted to U.S. regulators Monday. Knight stock, which had rallied 57 percent Friday to close at $4.05, slid 24 percent following the news Monday to settle at $3.07.

Knight stock had staged a sharp recovery Friday once various brokerage firms resumed trading with the troubled firm following news that it had managed to secure a line of credit, albeit temporary, that would keep it in business for the day. But its troubles that started after a trading glitch involving its systems on Wednesday resulted in a $440 million pretax loss had already cost the company's stock price more than 70 percent in value.

The preferred securities being sold now could eventually convert into some 267 million shares of common stocks of the company. Jefferies & Co., Getco, General Atlantic, Blackstone Group, TD Ameritrade, Stephens Inc. and Stifel Nicolaus are all listed as buyers, according to Knight’s latest press release.

“Knight’s financial position and capital base have been restored to a level that more than offsets the loss incurred last week,” Knight’s Chief Executive Officer Tom Joyce said in the release.

Thanking Wall Street supporters for their “steadfastness during a brief yet difficult period,” Joyce reiterated that the company is getting back to business as usual and the software that triggered Knight’s downfall has been removed from the company’s systems.

The swiftly moving story is one of the more astonishing developments in the world of electronic securities trading, where Knight plays a dominant role. The episode was centered 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 in the crucial time period of the crisis between 9:30 a.m. and 10:15 a.m. Eastern time.

The drama took a turn for the worse for Knight as Thursday’s trading session unfolded amid reports that players in the ETF traffic were actively avoiding Knight at least until any outstanding trades clear.  Indeed, Vanguard, the No. 2 U.S. 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,” the president of the King of Prussia, Pa.-based ETF trading firm added.

Freeze said the problem is that Knight settles its own trades, and those that do business with it now fear that Knight’s compromised finances could mean it won’t be able to settle on any number of trades that were outstanding at the time its trading system became unhinged. Street One doesn’t settle its own ETF trades.

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, Jersey City, N.J.-based 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

Industry sources say that whatever challenges Knight faces at this very moment pale in comparison to the attractiveness of its business—or at least particular pieces of it—to a party that has the resources to scoop up what is undoubtedly one of Wall Street’s most impressive market-making firms.

“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.

He said that many parties—from Wall Street investment banks to private equity firms—are likely to be interested in lending Knight a helping hand in order to gain a foothold in the business.

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

“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.

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