Knight’s $440 Million Loss Spurs Questions on Trade Cancel Rules

Knight Capital Group Inc.’s $440 million loss from a computer malfunction this month highlights the dangers of limiting human input in decisions about canceling trades, according to two industry executives.

Regulators should have discretion to reverse transactions when the outcome puts a firm’s survival at risk, said Neal Wolkoff, former chairman and chief executive officer of the American Stock Exchange and ex-head of ELX Futures LP. They should allow “do-overs” in extreme cases, said R. Cromwell Coulson, CEO of OTC Markets Group Inc. in New York.

Knight was forced to accept the loss on Aug. 1 when Chairman and CEO Thomas Joyce failed to persuade the U.S. Securities and Exchange Commission to let NYSE Euronext relax rules on voiding trades. While officials of the Securities Industry and Financial Markets Association and New York Stock Exchange said the regulations worked as planned, Coulson said there should be provisions for system breakdowns.

“We really need, as an industry, to have some points when the trade tape could be rolled back if something is going haywire and is not working right,” Coulson, whose firm operates marketplaces for equities not listed on U.S. exchanges, said in a phone interview. “This needs to be an option in the regulator’s toolbox to correct mistakes.”

Decisions should be made by the Financial Industry Regulatory Authority, which can bring together divergent views, and should apply when it’s clear the market isn’t functioning properly in its price-setting role, he said. Brokers should be forced to pay an “expensive price” for their errors, he said.

Unintended Orders

Knight’s computers bombarded the market with unintended orders just after trading began on Aug. 1, causing volume to surge and prices to swing in dozens of securities. NYSE Euronext said around 3 p.m. New York time it would cancel transactions in stocks before 10:15 a.m. that were at least 30 percent away from their price at the start of trading, a decision that applied to six securities out of 140 that were reviewed.

The exchanges and Finra, which oversees almost 4,400 brokers, revised their policies for so-called clearly erroneous executions after the May 6, 2010, plunge when the Dow Jones Industrial Average briefly fell 9.2 percent and trades involving

5.6 million shares were voided. New rules made their policies uniform and reduced exchanges’ flexibility to decide when to cancel, or bust, transactions.

Knight’s $440 million loss depleted its capital and forced it into a rescue by investors who bought securities convertible into a stake of more than 70 percent of the Jersey City, New Jersey-based firm. The company faced insolvency in the days following the Aug. 1 mishap as customers of its market-making unit took business elsewhere.

Regulatory Punishment

“At the end of the day, you’re punishing a firm for its own sloppiness, but almost to the point of extinction,” Wolkoff said. “If there were a regulatory punishment, it could still be punitive but wouldn’t take the firm out of existence.”

Knight declined to comment today, according to Kara Fitzsimmons, a spokeswoman.

A rational penalty should be imposed on firms that suffer technical malfunctions, “but that assessment can’t be the near-bankruptcy of a firm because of a line of code,” Wolkoff said. “It’s not a good thing to have institutions collapsing around you because of these freak occurrences.”

NYSE Euronext CEO Duncan Niederauer and Mary Schapiro, chairman of the SEC, said in separate comments on Aug. 3 that the exchanges followed the thresholds laid out after the 2010 plunge in deciding which Knight trades to bust.

Four Hours

In that case, it shouldn’t have taken four hours to publicize the ruling, said Tom Carter, managing director at JonesTrading Institutional Services LLC, a Westlake, California-based broker, and vice chairman of the Security Traders Association. He said the rules for errant trades shouldn’t be made more flexible.

“If the stocks were 30 percent out of whack, they shouldn’t have waited till 3 p.m. to cancel them,” Carter said. “It should have been done right away,” he said. After the flash crash, “there’s supposed to be a more stringent application of the rule. We need to reduce flexibility because money is at stake,” he said.

The rules for erroneous trades were adopted to reduce incentives for investors and market makers to withdraw from trading because of confusion about whether transactions would stand. Knight’s near-bankruptcy is the first incident in which the rules’ application almost led to a company’s collapse.

Canceled, Stand

Member firms of Sifma were generally satisfied with the certainty they had about which trades would be canceled and which would stand, according to T.R. Lazo, managing director and associate general counsel of the New York and Washington-based trade group. While the effectiveness of rules should always be assessed, Sifma hasn’t heard much interest in giving exchanges more discretion in this area, he said by phone.

“This is a significant event to the industry,” according to Joseph Mecane, head of U.S. equities at New York-based NYSE Euronext, who said in a phone interview that dialogue should continue about the rules for clearly erroneous executions. “A lot of CEE discussion centers on the tradeoff between discretion and certainty for the industry.”

Mecane said the exchange operator doesn’t immediately see anything “obvious” that should be changed.

Knight’s mishap came as brokers are pushing exchanges to take on more liability for their own system breakdowns when they cause financial losses for member firms or customers. Nasdaq OMX Group Inc. bungled the initial public offering of Facebook Inc. on May 18 and Bats Global Markets Inc. botched its own IPO on March 23, causing it to withdraw its shares from the public the same day.

Customer Effect

While Bats minimized the effect on customers by canceling all of its trades that day, Nasdaq OMX’s technology error led to hours of confusion among investors and brokers about whether or not they had received trades. Knight lost $35.4 million because of trading related to the Facebook IPO, while Chicago-based Citadel LLC lost as much as $35 million in its market-making unit, according to a person with knowledge of the firm.

Nasdaq OMX plans to reimburse its members up to $62 million for losses related to the Facebook IPO, the New York-based company said July 20. The cap on Nasdaq Stock Market’s liability stemming from specific technology errors and malfunctions it causes is $3 million, according to the exchange’s rules, and the higher payout is voluntary. Exchanges have immunity from losses related to activity they undertake as part of their duties as SEC-registered self-regulatory organizations.

Exchange Liability

“Broker-dealers take on a lot of liability and they question why exchanges, given their capacity as for-profit market participants, essentially have a regulatory liability protection,” Sifma’s Lazo said. “This is a good time to take a look at those rules and the purpose they serve and whether they ought to be changed.”

Sifma told the SEC in a 2007 letter that the commission should “re-evaluate the rules governing exchanges and market center liability” in light of system errors that had caused losses for brokers and their customers. The group said it was “very concerned” about the limitation of liability for exchanges as those operators were becoming for-profit companies.

Nasdaq OMX told the SEC in its July payout proposal that its accommodation was “unprecedented in its size.” It added that if exchanges face liability for “catastrophic losses,” the need to plan for that would be “reflected in the fees charged by exchanges to market participants in a manner that is not currently the case, making trading more expensive for all investors all the time.”

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