Knight Losses Spur Tighter Automated-Trading Rules From SEC

SEC Chairman Mary Schapiro
Mary Schapiro, chairman of the U.S. Securities and Exchange Commission (SEC). Photographer: Andrew Harrer/Bloomberg

The U.S. Securities and Exchange Commission is writing new rules in the wake of Knight Capital Group Inc. losses that could turn longstanding policies for how exchanges manage their automated systems into regulations.

After Knight suffered a $440 million trading loss Aug. 1 that almost put it out of business, the SEC began work to bolster existing policies meant to ensure the exchanges’ systems can safely handle trading demands, according to a person familiar with the SEC’s work who spoke on condition of anonymity because the process isn’t public.

SEC Chairman Mary Schapiro said in an Aug. 3 statement that she asked her staff to hasten work “to require exchanges and other market centers to have specific programs in place to ensure the capacity and integrity of their systems.” The agency will hold a Sept. 14 public meeting with industry participants to talk about “how we can strengthen the stability of our market structure while still preserving the many benefits of electronic trading,” Schapiro said in a statement today.

The malfunction at Knight tripped safeguards previously put into place by the SEC after technical faults caused the one-day, May 6, 2010, market crash, including activating single-stock circuit breakers to halt trading. Schapiro pointed out her agency’s recent market-access rules already require broker-dealers to keep tabs on their own trading systems “to ensure they are operating properly.”

1987 Legacy

The SEC’s so-called automation review policies, put in place with exchanges after the 1987 market crash, require the venues to notify the regulator of trading failures or security lapses. Portions of those policies will serve as the basis for the new rules, the person said.

Schapiro said in a March 2011 speech that compliance with the policies should be made mandatory. The Government Accountability Office urged such action in 2004, she said.

“These are policy statements, not rules,” Schapiro said in 2011. “They set out expectations that market participants would acquire appropriate technology and assure its functionality -- with regular capacity planning and testing exercises, and with system vulnerability assessments.”

The guidelines also state that exchanges should undergo an annual independent review and tell the SEC about “system outages and material system changes,” according to Schapiro.

“Such a regulation would require market participants to meet adequate standards for the capacity, resiliency, and security of their automated systems,” she said. “These rules could apply to exchanges, alternative trading systems handling appreciable volume, clearing agencies, depositories and securities information processors.”

-- With assistance from Nina Mehta in New York. Editors: Anthony Gnoffo, Maura Reynolds