Knight Market-Making Unit Says It Had ‘Technical Issue’

Computers sent more than 100 stocks into trading spasms just after U.S. markets opened, whipsawing investors and pushing shares of Knight Capital Group Inc. (KCG) down by the most ever on speculation it was to blame.

Knight, which helped execute almost $20 billion of equity transactions a day in June, plunged more than 30 percent in record volume. The errors were caused by a malfunction in a so- called trading algorithm, according to a person at the company who asked to remain anonymous. The New York Stock Exchange said that after reviewing 140 securities, it would cancel transactions in six that occurred during the height of the volatility starting at 9:30 a.m. in New York.

The disruptions, occurring after three Dow Jones Industrial Average stocks fluctuated in regular hourly patterns for a full trading day on July 19, emboldened critics of American market structure who say the computers that dominate trading have become too complex to control. Special curbs adopted after the May 2010 equity crash helped calm today’s fluctuations.

“All of a sudden, there was choppy trading and some stocks were halted,” Arthur Hogan, a strategist at Lazard Capital Markets LLC, said in a telephone interview. “People were scratching their heads, but it wasn’t a sense of panic. It was more curious. There’s got to be some human error here.”

Photographer: Scott Eells/Bloomberg

A trader works at the New York Stock Exchange. Close

A trader works at the New York Stock Exchange.

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Photographer: Scott Eells/Bloomberg

A trader works at the New York Stock Exchange.

Stock Swings

As the stock swings materialized, Knight told some clients of its market-making business that a “technical issue” was affecting its systems and advised them to route orders elsewhere. The issue was confined to that unit and its other operations were unaffected, the company said.

Goodyear Tire & Rubber Co. (GT) rose more than 10 percent before fluctuations in the stock narrowed and it finished up 6 cents at $11.51. In intraday trading, Manitowoc Co. (MTW) gained as much as 14 percent, Pandora Media Inc. climbed 11 percent and Level 3 Communications Inc. plunged 15 percent, according to data compiled by Bloomberg. None ended more than 4 percent away from the previous close.

The disruptions may further alienate investors who pulled money from mutual funds for five years. Share volume on American equity venues has fallen 13 percent this year amid rising volatility, concern the global economic recovery is slowing and disappointments such as the initial public offering of Facebook Inc., whose shares have fallen 45 percent.

“The pundits will begin to point toward yet another market mishap blamed on technology and how it further erodes retail investors’ confidence,” Mark Turner, head of U.S. sales trading at New York-based Instinet Inc., which accounts for almost 4 percent of daily U.S. equities volume, said in an e-mail.

Review Trading

NYSE Euronext (NYX) reviewed 140 securities, including Bank of America Corp., Caterpillar Inc. (CAT) and Pfizer Inc. In a decision made with regulators that it said isn’t subject to appeal, NYSE canceled trades in six where prices swung at least 30 percent in the first 45 minutes, according to a statement on its website.

Knight’s initial review indicated a “technology issue” occurred in the company’s market-making unit related to the routing of shares to the NYSE, according to an e-mail from spokeswoman Kara Fitzsimmons.

“Knight notified its market-making clients this morning to route listed orders away,” according to the statement. “The company’s OTC securities and trading in its other businesses are not affected. The company continues to review internally.”

The market-making business traded a daily average of $19.5 billion worth of equities in June with volume of 3.1 billion shares, according to its website.

Algorithmic Trading

The Jersey City, New Jersey-based firm is reviewing the possibility the error was generated by faulty software, said the person who asked to remain anonymous because the matter hasn’t been publicized. Market makers use algorithms to decide the prices at which they want to buy and sell and the number of shares they’re willing to provide or accept.

More than 63 million shares of Knight changed hands today, the most ever, according to data compiled by Bloomberg. The number of bearish options traded on Knight soared to a record.

Nasdaq OMX Group Inc. said in an e-mail that it is investigating “potentially erroneous” transactions. Robert Madden, a spokesman for the exchange, declined to comment further.

“As is our practice, we are closely monitoring the situation and in continuous contact with the NYSE and other market participants,” Kevin Callahan, a spokesman for the Securities and Exchange Commission, said in an e-mail.

Opening Prices

Trades that occurred 30 percent above or below the opening price in Wizard Software Corp., China Cord Blood Corp. (CO), Reaves Utility Income Fund, E-House China Holdings Ltd., American Reprographics Co. and Quicksilver Resources Inc. will be voided, according to a statement on the NYSE website.

As the unusual price patterns were materializing, NYSE employees took steps to stabilize individual stocks, Jason Weisberg, head of institutional trading for Seaport Securities Corp., said in a telephone interview from the exchange.

“Things were always calm,” Weisberg said. “When the price dislocations were popping up all over the room, exchange officials picked up on the anomalies and put the brakes on. It was happening so frequently and simultaneously they didn’t catch everything, but they caught most very fast.”

Trading was halted on at least five stocks on the NYSE after they tripped so-called “circuit breakers” designed to prevent excessive moves. China Cord Blood soared 143 percent; CoreLogic Inc. fell more than 11 percent; Trinity Industries Inc. rose 17 percent; Kronos Worldwide Inc. climbed 19 percent; and Molycorp Inc. fell 18 percent.

Repeating Patterns

Investors in three of the biggest Dow (INDU) stocks witnessed repeating fluctuations on July 19, fueling speculation the moves were a consequence of computerized trading. Shares of International Business Machines Corp. (IBM), McDonald’s Corp. (MCD) and Coca-Cola Co. (KO) swung between successive lows and highs in intervals that began near the top and bottom of each hour.

Regulators have increased scrutiny of computerized strategies that rose to prominence in the U.S. after more than a decade of market structure reform. The SEC and Commodity Futures Trading Commission blamed a broker’s algorithm for setting into motion the events that caused the May 6, 2010, market crash that briefly erased $862 billion from U.S. equities in less than 20 minutes.

Algorithms are automated trading strategies that can be used to break larger buy or sell orders into smaller pieces over a specified period of time such as an hour or day. Traders at fund managers or brokers use them to mute price impact and mask their activity as they try to scoop up visible and hidden orders spread across exchanges and alternative venues such as dark pools and provide bids and offers to other investors.

VWAP Analysis

A volume-weighted average price, or VWAP, strategy seeks to buy or sell stock over a certain period, weighted for the number of shares traded at different levels. A percentage-of-volume algorithm will try to account for a specified share of trading volume in a company’s stock to avoid buying or selling that moves the stock price. More aggressive and tailored algorithms exist to fine-tune trading based on market conditions such as changes in volume, volatility or the price movements of indexes.

The SEC voted last month to require exchanges and the Financial Industry Regulatory Authority to build a single system to monitor and analyze trading activity on U.S. equity and options markets. The rule mandates a so-called consolidated audit trail to expedite surveillance across 13 equity exchanges, 10 options markets and more than 200 broker-dealers that execute stock trades away from public venues.

The effort is part of the agency’s response to the May 6, 2010, stock rout that temporarily sent the Dow down almost 1,000 points. The so-called flash crash was triggered by a mutual fund firm’s algorithmic trade that sparked the rapid selling of financial futures because it took into account volume but not price or time, according to a report released by the SEC and CFTC in October 2010.

“It’s troubling,” Jack Ablin, chief investment officer at BMO Harris Private Bank in Chicago, which oversees about $60 billion of assets, said in a phone interview. “It’s just one other reason for individual investors to stay away from the market.”

To contact the reporters on this story: Whitney Kisling in New York at wkisling@bloomberg.net; Lu Wang in New York at lwang8@bloomberg.net; Joshua Fineman in New York at jfineman@bloomberg.net

To contact the editor responsible for this story: Lynn Thomasson at lthomasson@bloomberg.net

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