SEC Begins Formal Inquiry Into Knight Related to Computer Error

Knight Capital Group Inc.’s $457.6 million trading error in August is the subject of a formal investigation by the Securities and Exchange Commission.

Federal examiners are assessing the firm’s compliance with a rule governing risk-control procedures in its trading operation and other regulations, the company said in a filing with the commission yesterday. Knight was also the subject of on-site examinations into its capital and liquidity conditions, it said. Those inquiries have concluded.

The trading mishap, which Knight blamed on faulty software, pushed the Jersey City, New Jersey-based firm to the brink of bankruptcy and accelerated an industrywide assessment of how to improve controls in electronic trading systems. SEC Chairman Mary Schapiro described the mishap as “unacceptable” and promised to issue regulations to help prevent similar events.

“It was expected that the SEC would look into Knight’s operations,” Richard Repetto, a New York-based analyst at Sandler O’Neill & Partners LP, said in a phone interview. “There are rules in place that would presumably prevent these mishaps, but then again human errors do occur.”

The SEC is examining Knight’s compliance with the so-called market-access rule, adopted in 2010 to reduce the risk of trading disruptions and improper and manipulative activity. The rule, which went into effect last year, requires brokers to employ risk checks on orders before they’re sent to markets to make sure they aren’t erroneous and don’t exceed preset capital and credit levels.

Erroneous Orders

“The item in the 10-Q relates to ongoing discussions with the SEC since early August, discussions which have been previously disclosed, including the third-quarter conference call,” Kara Fitzsimmons, a spokeswoman for Knight, said in an e-mail about the regulatory filing.

Knight bombarded U.S. equity exchanges with erroneous orders on Aug. 1 after improperly installing software that malfunctioned, according to CEO Thomas Joyce. The trading caused volume to surge and prices to swing in dozens of securities listed on the New York Stock Exchange and NYSE Arca.

Knight was taken over by six Wall Street firms including Jefferies Group Inc. and Blackstone Group LP in August after losses associated with the computer malfunction depleted its capital. The investors, who paid $400 million for securities convertible into more than 70 percent of Knight’s equity, are represented by three new Knight directors.

Technology Chief

In September, the firm consolidated oversight of its finances and operations under a single executive and reassigned its technology chief. Steven Bisgay, Knight’s chief financial officer since August 2007, was named to the additional post of chief operating officer. Steven Sadoff, the executive who had been in charge of operations and technology, moved to a role with Knight’s clearing, prime brokerage and futures businesses.

Knight has separated its processes for developing software and installing it to ensure they’re now done by different people, Joyce said on a conference call Oct. 17. It instituted more checks and balances to reduce the chance of a similar mistake occurring and implemented controls on systems that send orders to markets “so we can get to the router faster and stop it from creating problems sooner,” he said.

Knight was “close to having resolution” with the SEC about its Aug. 1 trading, Joyce said at the time.

Kill Switches

A group of market and trading professionals said exchanges should introduce so-called kill switches or mechanisms that shut down a firm’s trading if it exceeds a specified maximum to help limit errors by customers. They may have reduced Knight’s losses on Aug. 1, the group told the SEC in September. Controls should supplement curbs put in place by brokers, who remain responsible for their own trading malfunctions, the executives said.

“That’s really meant to be a second stop to some of the requirements that are already out there around market-access controls,” the testing of software and the supervisory responsibilities of brokers, Joe Mecane, head of U.S. equities at NYSE Euronext, said at an online conference sponsored by the Investment Company Institute on Nov. 2.

There’s no “silver bullet” for technology malfunctions, James R. Burns, deputy director of the SEC’s division of trading and markets said at the conference. He said the SEC is working on a proposal to convert guidelines from two decades ago about how exchanges manage their automated systems into a regulation. This is an “area that has long deserved revisiting,” he said of the so-called automation review policy program.

Dark Pools

The requirements may be extended to large brokers and dark pools, venues that don’t display price quotations, David Shillman, associate director in the SEC’s division of trading and markets, said at a conference in New York in September. The aim is to codify and expand rules designed to enhance market stability and make them enforceable, he said.

The SEC has moved under Schapiro to get a better handle on changes to fast-paced, electronic markets. In January 2010, before the so-called flash crash, the agency issued a paper seeking comments on a wide range of issues, including high-frequency trading, dark pools and new trading strategies.

It implemented circuit breakers for individual stocks and approved regulations laying out the rules for breaking erroneous trades later in 2010. At least five stocks were halted on the NYSE on Aug. 1, according to data compiled by Bloomberg.

In May, the agency approved two plans to lessen the chances of sudden market swings. One system, known as limit-up/limit-down, will prevent trades at prices outside a specified range. The other plan will make it easier to trip the market-wide circuit breakers, introduced after the 1987 crash, that are designed to halt trading during routs. The index triggering the curbs and the price decline required to stop all trading were changed. The rules will go into effect in February.

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