Knight Algo Nightmare Dents Market as Trader Sounds Alarm

Knight Algo Nightmare Dents U.S. Market as Cangemi Sounds Alarm
A trader works on the floor of the New York Stock Exchange. Photographer: Jin Lee/Bloomberg

As computer errors at one of the largest U.S. market makers sent stocks swinging as much as 151 percent, Joseph Cangemi, a broker at ConvergEx Group, acted like a driver approaching a car crash. He slowed down.

“You have to put on your extra-sensitivity helmets and look for every possible bit of information to make prudent decisions,” said Cangemi, the head of equity sales and trading at the New York-based firm. “We were in a heightened state of alarm and we’re actually still in a heightened state of alarm.”

The New York Stock Exchange reviewed trading in 140 stocks from Molycorp Inc. to AT&T Inc. yesterday as the market’s open was rocked. Shares of Knight Capital Group Inc., whose algorithms help execute about $20 billion of trades on an average day, tumbled the most ever on speculation it was responsible. Trades that occurred during the height of the volatility were canceled in six securities.

Knight said today that losses from the trading breakdown are $440 million, almost quadruple its 2011 net income and more than some analysts had estimated, and the firm is exploring strategic and financial alternatives. Its stock plunged 63 percent to $2.58 at 4 p.m. in New York today for a two-day slump of 75 percent.

While almost all stock transactions in the U.S. used to be handled by three exchanges, regulations to increase competition and reduce costs have fragmented markets across about 50 different venues, raising concerns about integrity when the computers that increasingly dominate trading malfunction. For some investors, yesterday’s disruptions were a reminder that the issues raised in May 2010 when the so-called flash crash briefly wiped out $862 billion from U.S. equities have yet to be solved.

‘Spilled Coffee’

“Everyone’s scratching their heads and going, ‘OK, well, who spilled coffee on the computer again?’” Peter Sorrentino, who helps oversee $14.7 billion as a senior money manager at Huntington Asset Advisors in Cincinnati, said in a phone interview. “After the flash crash, anytime you see something like this, you definitely pause.”

The Securities and Exchange Commission and Commodity Futures Trading Commission blamed a broker’s algorithm for setting into motion the events that caused the market crash in May 2010.

Stocks Reviewed

Among the stocks that were reviewed by the NYSE were nine members of the Dow Jones Industrial Average, companies with almost $1 trillion in combined market value. They included Alcoa Inc., American Express Co., Bank of America Corp. and AT&T.

Instant messaging systems used by traders were full of messages saying “What the heck, what’s going on, there’s no news, I’m not aware of any news, dig into this, has anybody heard anything?” said Brian Barish, who oversees $7 billion as president and chief investment officer at Denver-based Cambiar Investors LLC.

As the stock swings mounted with Dole Food Co. rising as much as 15 percent and Harley-Davidson Inc. falling as much as 12 percent, Knight advised clients to route orders elsewhere. The issue was confined to its market-making unit and its other operations were unaffected, the company said.

Voided Trades

Trades that occurred 30 percent above or below the opening price in Wizard Software Corp., China Cord Blood Corp., 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.

Knight’s technical issue came less than two weeks after investors in three of the biggest Dow stocks were whipsawed by price swings that repeated every hour, fueling speculation the moves were a consequence of computerized trading. The cause of that incident hasn’t yet been determined.

The fluctuations also follow the Facebook Inc. initial public offering in May, when Nasdaq OMX Group Inc. botched the opening auction of the social network’s shares. That came two months after the withdrawal by Bats Global Markets Inc. of its IPO when the market company couldn’t get its own stock to trade on its exchange.

Automated Technology

“It’s like technology out of control,” Kenneth Polcari, managing director at ICAP Plc’s equities unit and a floor trader at the New York Stock Exchange, said in a telephone interview. “How many times have we seen this? We saw it happen on Nasdaq with Facebook. We’ve seen it happen in other technology platforms. What’s frustrating about this is that the business has become so automated and electronic that in certain times, you don’t feel like you have control.”

Thomas Joyce, Knight’s chief executive officer, was among the most vocal critics of the Nasdaq Stock Market for its mishandling of the Facebook IPO. His firm lost $35.4 million in trading related to the May 18 debut.

“Their technology failed and then there were a series of decisions made after the technology failed that were unfortunate,” Joyce said in a July 19 interview on Bloomberg Television. “That organization will learn from what happened that day and I have no doubt will improve upon it.”

Flash Crash

Stock traders on desks during the so-called flash crash two years ago said that while they were reminded of the incident yesterday, the scope of the issue was not as great as when the Dow slid as much as 998.5 points on May 6, 2010.

“This is the flash crash of the week,” Doug Roberts, chief investment strategist for Shrewsbury, New Jersey-based Channel Capital Research, said in a telephone interview. “This is saying that we haven’t really fixed a lot of our problems. We haven’t really dealt with them, and they’re not going to disappear. The fundamental underpinnings are still a problem. It could definitely happen again.”

The disruptions may discourage investors who pulled $135 billion from U.S. stock mutual funds last year, the highest total after 2008. Share volume on American equity venues has fallen 13 percent this year amid rising volatility and concern the global recovery is slowing.

Circuit Breakers

At least five stocks were halted on the NYSE by so-called circuit breakers during the first 35 minutes of trading, according to data compiled by Bloomberg. China Cord Blood Corp., a stem-cell services company with a market value of $177.7 million, surged as much as 151 percent and was paused at 10:04 a.m. in New York. Some of the trades were later canceled. Molycorp Inc., which produces rare-earth minerals, was halted at 9:53 a.m. after losing 18 percent.

The volatility curbs stop trading in a stock when a company’s shares move 10 percent in five minutes. The circuit breakers, as well as requirements that market makers supply quotes closer to the best available prices and a uniform system across exchanges for canceling errant transactions, are a legacy of the 2010 flash crash.

“That was marketwide, that was huge volume, that was massive, and that was a lot of money on the move,” Sorrentino at Huntington Advisors said of the 2010 event. “This morning it was money but it wasn’t akin to that. Everybody put their fears of Mayan prophecies aside and just said, ’This looks weird.’”

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