Knight $440 Million Loss Sealed by Rules on Canceling Trades

Regulations put in place to protect investors after $862 billion of market value was briefly erased on May 6, 2010, were the same rules that almost ruined Knight Capital Group Inc. this month.

Knight, whose market-making unit executes 10 percent of U.S. equity volume, lost $440 million on Aug. 1 and its stock has plunged 73 percent after a computer malfunction bombarded the market with errant orders that exchanges declined to cancel. A decade ago, the firm suffered almost no consequences in a similar breakdown when officials agreed to void trades after Knight unintentionally sold 1 million of its own shares.

The refusal to let Jersey City, New Jersey-based Knight out this time shows that brokers face increasing risks from technology errors after regulators toughened rules following the so-called flash crash two years ago. Knight, which mistakenly bought and sold exchange-traded funds and New York Stock Exchange companies, was forced into a rescue that ceded most of the firm to six investors led by Jefferies Group Inc.

“This is really a wake-up call,” David Whitcomb, founder of Automated Trading Desk LLC, a Knight rival bought by Citigroup Inc. for $680 million in 2007, said in a telephone interview. “They made one obviously terrible mistake in bringing online a new program that they evidently didn’t test properly and that evidently blew up in their face.”

Erroneous Trades

Knight has been upended by computer errors before. On June 2, 2002, three days after Thomas Joyce started work as chief executive officer and president, its stock tumbled more than 50 percent intraday when a software flaw caused its computers to spew out orders to sell the company’s shares. The Nasdaq Stock Market and Cincinnati Stock Exchange canceled the transactions and Knight later pared the loss to 7 percent.

The May 2010 flash crash inaugurated reforms aimed at reducing the discretion exchanges have to cancel trades. The Dow Jones Industrial Average tumbled almost 1,000 points in 20 minutes that day before rebounding after the automated sale of stock futures helped trigger waves of selling, according to a report by the Securities and Exchange Commission and Commodity Futures Trading Commission on Sept. 30, 2010.

Rules Stiffened

Rules formalizing the treatment of erroneous trades were adopted amid criticism by investors after exchanges and the Financial Industry Regulatory Authority voided transactions totaling 5.6 million shares on May 6, 2010. Regulators added guidelines governing when sales or purchases of stock could be canceled after market makers said confusion about which trades would stand prevented them from acting during the rout.

The rules had their biggest effect earlier this month after Knight’s unintended orders caused volume suddenly to surge and prices to swing in dozens of securities just after trading began. Executives at the New York Stock Exchange canceled transactions that were 30 percent or more away from their price at the start of trading, a decision that applied to six securities out of 140 that were reviewed.

Unwanted transactions occurred in ETFs listed on NYSE Arca and in companies on the Big Board, Knight said in a regulatory filing Aug. 9. It previously hadn’t said its mishap affected ETFs. An update to software made in preparation for an NYSE program to lure more individual investors to the Big Board caused the mistaken orders starting at 9:30 a.m. New York time.

Fixing Error

Knight’s loss stemmed from old software that was inadvertently reactivated when the new program was installed, two people briefed on the matter said. Once triggered, the dormant system started multiplying stock trades by one thousand, according to the people, who requested anonymity because the firm hasn’t commented publicly on what caused the error. Knight’s staff spent 45 minutes looking through eight sets of software to determine what happened, the people said.

“It was a new application,” Joyce, now chairman and CEO, said in a phone interview with Bloomberg News Aug. 6. “It was certainly a technology issue that had been engineered to allow us to better interact with the retail liquidity program at the New York Stock Exchange, and it was obviously a greatly flawed application.” Joyce asked the SEC to give NYSE more flexibility to cancel trades because they were “one big error,” he said.

Preventing Injury

Even as Knight suffered, the changes prevented its mishap from injuring market participants, Matthew Andresen, co-CEO of quantitative trading firm Headlands Technologies Inc., said.

“The market handled it well,” Andresen, a former Citadel LLC executive, said in a phone interview. “The harmonization of the clearly erroneous policy worked very well and the plumbing worked very well. Unfortunately for Knight, they ended up making a $440 million donation to the marketplace.”

Securities professionals are still attempting to dissect what went wrong at Knight, whose incident followed the cancellation of an initial public offering by Bats Global Markets Inc. on March 23 and the May 18 IPO by Facebook Inc. on Nasdaq OMX Group Inc., which was marred by technology failures and delayed trade confirmations.

While preparations for the NYSE’s retail liquidity program led to the error, Knight’s loss didn’t occur within the program, nor did it originate with its market-maker group on the NYSE trading floor, according to a person with direct knowledge of the matter who declined to be identified because the information isn’t public. Joyce said the error that led to Knight’s loss was an “infrastructure problem” in an interview with Bloomberg Television on Aug. 2.

Profits, Losses

Such an issue may involve bad software that leads a company to trade in ways it doesn’t expect, according to George Hessler, former CEO of Stock USA Execution Services Inc. who was also an executive at Lime Brokerage LLC, trading firms that specialize in high-frequency electronic transactions. Malfunctioning controls may also have prevented systems from updating the firm’s profits and losses based on messages sent back by the exchange, he said.

“A software problem could have made the firm not aware of their own positions,” according to Hessler, who said in a phone interview he had no first-hand knowledge of Knight’s situation. “But good programming discipline also means there should be last-ditch backstop mechanisms to shut down trading when too many orders are going out or orders aren’t getting updated the way they should be.”

Bid, Ask

Knight appeared to repeatedly send orders “where they were buying at the offer and selling at the bid, and some were on stocks with wide bid-ask spreads,” Manoj Narang, CEO of Tradeworx Inc., a high-frequency firm and technology provider based in Red Bank, New Jersey, said in a phone interview.

“It was a slow, painful, 15-cents-at-a-time death by small cuts, only it was happening every fraction of a second because computers are fast,” he said.

His automated trading firm experienced a similar mishap earlier this year in a broker’s dark pool, or private venue, he said. Firms supplying liquidity generally do so at the bid and offer prices. While Tradeworx’s issue occurred because of system changes the firm didn’t know about, the strategy was programmed to shut off after it lost $5,000, which took less than a minute, Narang said.

“What is confusing virtually everybody, including me, is why Knight didn’t have an automated stop loss in their strategies,” he said. “It was the first day of NYSE’s RLP program so there should have been multiple layers of risk controls. In addition to having automated stop losses there should have been humans watching the strategy like a hawk.”

‘Within Minutes’

NYSE Euronext was in touch with Knight “within minutes” after identifying the source of the errant trades on Aug. 1, the exchange’s CEO, Duncan Niederauer, said on a conference call two days later. Knight participated in user testing associated with the start of NYSE’s retail liquidity program, he said, calling the problem that befell the member firm a “routing error.”

NYSE held a call with other stock exchanges and Finra from 10:30 a.m. until about 4 p.m. on Aug. 1, according to people with direct knowledge of the matter who declined to be identified because the discussion was private. The Big Board talked separately to the SEC and Knight, one of the people said.

Early in the call, exchange officials discussed whether the Knight trades could be treated individually instead of as a group event for determining when transactions could be canceled and at what price, according to one of the people. The threshold for voiding trades in an incident involving 20 or more securities is 30 percent.

Individual Events

Defining the errors as individual events may have spared Knight from greater losses because it means more trades are eligible for cancellation. In most cases, trades that occur 10 percent or more away their previous price can be voided when the error involves a single security. Officials from NYSE Arca and Nasdaq argued against this, one of the people said.

Robert Madden, a spokesman for Nasdaq OMX Group Inc., and Richard Adamonis, a spokesman for NYSE Euronext, declined to comment. Joyce said Aug. 2 the mishap was Knight’s fault.

Knight will hire an outside adviser to investigate what led to the losses, Kara Fitzsimmons, a spokeswoman, said Aug. 10. She declined to comment about what happened Aug. 1 beyond what the company already disclosed.

NYSE announced just before 3 p.m. it would cancel trades that occurred before 10:15 a.m. with price movements of at least 30 percent from their opening levels. Niederauer and Mary Schapiro, the chairman of the SEC, said in separate comments on Aug. 3 that the exchanges followed the thresholds laid out after the 2010 plunge.

“Technology people at trading firms are probably thinking, ’There but for the grace of god go I,’” said James Angel, a professor at Georgetown University’s business school in Washington. “Every chief technology officer is thinking they don’t know what’s buried in some line of code or what unanticipated change will lead to failure. When unanticipated problems occur, operations people may face situations they’ve never seen before and don’t know what to do. It’s scary.”