The problems afflicting market-maker Knight Capital (NYSE:KCG) appear to have had a notable of effect on ETF spreads, according to analysis by IndexUniverse, a leading US-based ETF research and analytics provider. Market-makers help provide liquidity for ETFs by being willing buyers and sellers.

A software glitch at Knight Capital Group (NYSE:KCG) appears to have impacted bid/ask spreads for less liquid ETFs.

Knight Capital experienced a significant technology malfunction at the open of trading on the NYSE on Wednesday 1st August. The malfunction was related to the installation of trading software and resulted in Knight sending numerous erroneous trade orders into the market.

While the glitch was picked up and isolated speedily, the erroneous trades resulted in a realised pre-tax loss of approximately $440 million, severely impacting the company’s capital base.

As a consequence of this error and subsequent financial loss, the company’s market-making activities in ETFs seem to have been affected. The effect has been particularly notable in less liquid ETFs, for which Knight is one of the largest market-makers. Knight was number one ETF market-maker on the NYSE with a 17.2% market share for the first quarter of 2012, according to Thomas Reuters AutEx.

For less liquid ETFs, typically those ETFs that trade fewer than 50,000 shares per day, market-makers like Knight ensure that trades get executed at prices within an acceptable bid/ask range (known as the ‘spread’). However, the day after Knight announced the trading error the average spread for the 549 less liquid ETFs for which Knight acts as the lead market-maker widened threefold, jumping from 0.49% to 1.53%, according to IndexUniverse.

While the impact on liquid, higher volume ETFs (those that tend to trade more than 50,000 shares per day) has been negligible, with spreads widening by just 1 basis point, from 0.12% to 0.13% according to IndexUniverse, the increased spread for less liquid ETFs has been sufficient enough to negatively impact investor returns.

Encouragingly, ETFs tend to have more than one market-maker and competition within this space is healthy, meaning that the widened spreads that currently exist should not last too long as other market-makers are expected to pick up the slack.

Indeed, ETF issuers for which Knight is the lead market-maker are understood to have contacted rival market-makers, such as Goldman Sachs, IMC Chicago, Susquehanna Capital Group, Getco and Timber Hill, to ensure that they be prepared to step in should spreads materially widen in their ETFs.

However, until some of these market-makers step in with extra liquidity, there is likely to be a continued, albeit temporary, gap in liquidity. In the meantime, therefore, investors would be wise to pay close attention to ETF spreads, particularly for less-frequently-traded ETFs.

Relief for ETF spreads may actually soon come from Knight itself as the company’s operations are by no means a write-off and the company’s broker/dealer subsidiaries are understood to be in full compliance with regulatory requirements. The company has also vowed to continue its trading and market-making activities.

In addition, Knight has been actively pursuing strategic and financing alternatives to strengthen its capital base and reports suggest that the company is now close to reaching a $400m rescue deal with a group of investors believed to include Blackstone Group and TD Ameritrade. The Chicago-based market-maker Getco and financial services companies Stifel Nicolas, Jefferies Group and Stephens Inc are also reported to be involved. Should a deal go through, ETF spreads could well quickly return to normal.