Knight Capital, a market-maker, entered into billions of dollars in unwanted trades in 2012, resulting in a loss of about $440 million once unwound. This was not the result of any unauthorized trading by a rogue employee but by a coding error that allowed trades to be made without limit as a result of what were supposed to be quite small orders. Such problems are relatively new, the result of modern automated trading systems. Though beneficial for many reasons, automated trading introduced new technology risks to financial markets.

Trading

           A market-making and trading firm, Knight Capital was a leader in its industry. The 17-year-old, New Jersey-based firm had a $1 billion market cap in 2012 and the company executed $20 billion in trades in a typical day. This made Knight the largest U.S. retail market-maker active on both the New York Stock Exchange and the Nasdaq and in stocks traded over-the-counter as well. Its trading represented about 10% of all trading on listed equity securities in the United States.

            Knight used computer algorithms to make a market in many shares and also handled trading in Exchange Traded Funds. As a market maker, the company would buy and sell stocks on behalf of exchanges so that investors could always find a counterparty. The goal was to enhance the usefulness of the exchange to investors. Knight relied on automated trading to do this; automated trading could increase the speed at which orders were executed while also reducing cost, of critical importance for market-makers and even helpful to all investors.

Glitch

           Soon after the market opened on Wednesday August 1, 2012, it became clear something strange was happening. Some stocks were seeing strange price behavior, large swings in prices without obvious reason. Something like this has happened before, often caused by a large hedge fund unwinding positions; but in this case, it was a trading error, or a series of trading errors, originating with Knight. When processing two hundred and twelve small retail orders something in Knight’s system triggered much larger volumes of trades, millions of unintended trades across about one hundred and fifty stocks over about forty-five minutes, beginning around 9:30am and continued until about 10:15am.

           A botched software installation was to blame. Knight installed new software to integrate with a New York Stock Exchange ‘Retail Liquidity Program’ system also being deployed that Wednesday. The software would have taken an order from another part of Knight’s platform and send the order outbound for execution at an external venue based on its liquidity. The order might be broken into parts with some sent to different venues. Once the order was executed in full, this process would stop for that trade.

           However, the new software was causing some dormant code in old software to be called again, code related to a product feature that had been retired in 2003, without proper testing or review. The code allowed trades to be made without volume caps. Essentially, orders were routed for execution without considering if the order has been already fulfilled first. Making matters worse, there was seemingly no simple ‘kill switch’ that could stop the unwanted trading quickly.

            Because of the glitch, nearly four hundred million shares were traded during those forty-five minutes across four million executions. In the case of larger companies, the share price impact was muted. Dupont shares rose perhaps around 3% before falling back to their opening price at around 10am and Berkshire Hathaway fell about 2% before recovering at about the same time. Less liquid stocks subject to the error saw larger moves; Quicksilver shares rose about 20% before falling 30% or so from that peak. In thirty-seven listed stocks, prices moved by more than 10% and across these, Knight was responsible for 50% of trading volume.

Loss

           At the end of the disorder, Knight Capital had an unwanted net long position of $3.5 billion across eighty stocks and $3.15 billion across unwanted net short positions in seventy-four stocks. Because of the price swings, the result of these billions in unwanted exposures was a loss of between $440 million to $460 million. The company did have $365 million in cash on hand but a lot of this would have been required for regulatory purposes. So, it was a certainty that some drastic action was needed.

           New capital would need to be raised but this was not easy to do so quickly as was needed. Trades made Wednesday would not need to settle until the following Monday under the laws requiring a T+3 settlement period for listed stocks, so the company had three business days at its disposal but that was it. Knight Capital was itself publicly traded and its stock fell 63%. The company, including the CEO who had just had a surgery the day before the error, spent the rest of the week looking for capital or a buyer.

           During these days, counterparties like brokerage firms stopped doing business with Knight, particularly by rerouting their trading through other firms for execution. This was not necessarily unwelcome because reduced trading meant Knight could free up cash that otherwise would be required to be maintained for complying with capital sufficiency rules, since these were linked to trading volume. To free up cash, Knight was even asking some clients to send their trades elsewhere.

Recapitalization

           Knight Capital and its bankers spoke to ninety potential investors across the five days between Wednesday and the following Monday. A merger with Virtu, a competitor, was immediately raised as a possibility. Another competitor through one line of its business was Citadel Securities and it offered a loan to Knight.

            In the end, Knight opted to sell $400 million of preferred stock to an investor group led by Jefferies Group. This amounted to a sale of 73% of the company. Besides Jefferies, the investors included Blackstone and Getco, the latter another competitor of Knight. These were the major participants but alongside them were TD Ameritrade, Stifel Nicolaus and Stephens. This investment was closed on Monday when the company needed to receive the cash to settle its trades.

            Within a couple weeks of the incident, the company’s status with the New York Stock Exchange was reinstated, its full market-making duties with the exchange restored, and Knight regained some of the transaction volume it had lost. The company also announced the appointment of a chief risk officer with oversight over financial and operational risk and hired IBM to investigate its software development.

            IBM would not be the only outsiders looking into the firm. The Securities and Exchange Commission also investigated, and even fined, Knight Capital. The SEC, in a 2013 report, said that “Knight’s system of risk management controls and supervisory procedures was not reasonably designed to manage the risk of its market access.” The regulator cited a myriad of shortfalls in controls, written policies, and reviews.

Lesson

            Automated trading has brought many benefits. Manual work in executing orders means the investor pays a lot more to place the trade, the order takes longer to execute, may not be executed even partially, and the investor may be subject to hours of uncertainty not knowing whether their trade will even be executed by the end of the day. Automatic trading may even reduce the rate of errors but it seems to make large trading errors more likely. Still, such problems are relatively rare and the costs, though large, seem small in comparison to the efficiencies gained. Regulations and capital requirements do help protect investors from the risk a firm may not be able to settle their trades. However, the experience of Knight shows just how susceptible to technology risk, hard to measure from outside, this industry is.

More from the Tontine Coffee-House

           Read how the transatlantic cable transformed trading across international markets and disorder in markets caused by trouble with quantitative hedge funds. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts. 

Further Reading

1.      Berkowitz, Ben, and John McCrank. “Knight Regains Market Share, under Pressure over Rescue | Reuters.” Reuters, 7 Aug. 2012.

2.      Charette, Robert N. “‘Knuckleheads’ in It Responsible for Errant Trading, Knight Capital CEO Claims.” IEEE Spectrum, 14 Sept. 2012.

3.      “In the Matter of Knight Capital Americas LLC Respondent.” 16 Oct. 2013.

4.      Strasburg, Jenny, and Jacob Bunge. “Knight Capital Swamped by Glitch Loss.” Wall Street Journal, 2 Aug. 2012.

Comments (3)

  1. Reply

    Power in Contemporary Society We need a College Undergraduate Mulitidisiplined Class in Economics
    Political Science and Sociology This article is Reguired Reading Keept Them Comiming

    Many Thanks for all your Doing

    Sormin Norman

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