Knight Trading Loss Said to Be Linked to Dormant Software

Knight Capital Group Inc.’s $440 million trading loss stemmed from old computer software that was inadvertently reactivated when a new program was installed, according to two people briefed on the matter.

Once triggered on Aug. 1, 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 looked through eight sets of software before determining what happened, the people said.

“Whenever there’s software involved, there’s always a danger of something going wrong,” Sang Lee, managing partner at research firm Aite Group LLC in Boston, said in a phone interview. Lee had no first-hand knowledge of Knight’s situation, he said. “It’s a risk everyone lives with, not just in the financial services world.”

Knight, based in Jersey City, New Jersey, hasn’t explained in detail what caused the trading loss, which depleted its capital and led to a $400 million rescue that ceded most of the company to a group of investors led by Jefferies Group Inc. The 45-minute delay in shutting down the malfunction has confused some securities professionals, who say that trading programs can typically be disabled instantly.

‘Infrastructure Problem’

“This software problem was an infrastructure problem,” Chairman and Chief Executive Officer Thomas Joyce, 57, said in an Aug. 2 interview with Bloomberg Television’s “Market Makers.” “It was more of a networking problem as opposed to using quantitative tools to trade.”

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 canceled trades that were 30 percent or more away from the price at the start of trading, a decision that applied to six securities out of 140 that were reviewed.

The company was updating software in preparation for an NYSE plan aimed at luring more individual investors to the exchange, Joyce said in the Aug. 2 interview, without offering details. The Big Board’s so-called retail liquidity program, designed to attract smaller investors by giving them superior prices, was being implemented that day.

Market Making

The company, whose market-making unit executes about 10 percent of U.S. share volume, will hire an outside adviser to investigate what led to the losses. The company is conducting an in-depth review, Kara Fitzsimmons, a Knight spokeswoman, said in an e-mailed statement.

“As previously stated, on Aug. 1, 2012, Knight experienced a technology issue at the opening of trading related to Knight’s installation of software for its NYSE-listed market making business,” she wrote. “We have been working with clients continually and we are gratified to see the return of order flow to the company.”

Knight stock increased 5.3 percent to $2.99 today.

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 in the market crash of 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.

Investor Group

Getco LLC, an automated trading firm, Blackstone Group LP, brokerages Stifel Nicolaus & Co. and TD Ameritrade Holding Corp. and the investment banks Stephens Inc. and Jefferies paid $400 million on Aug. 6 for preferred stock that will convert into 267 million common shares. Knight, which closed at $10.33 the day before the trading error, ended yesterday’s session at $2.84.

The accidental trading at Knight follows 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.

The growth of electronic trading over the last 15 years has transformed markets, first for Nasdaq stocks and later for NYSE-listed companies. Racks of computers usurped or joined human traders unable to analyze real-time data and market conditions quickly enough to act in split seconds. There are more than 50 venues on which to trade, often making decisions about where to send orders and at what price too complex for individuals.

High-frequency firms and market makers like Knight compete for computer science experts, software and network engineers, system administrators, and staff to conduct quality assurance tasks, according to Anthony Dostellio, managing partner at Objective Paradigm, a technology recruiting firm in Chicago that works with trading companies.

Programming Language

High-speed programs that funnel orders to markets need software engineers who can write code in the programming language known as C++ and for a Linux operating system, he said in a phone interview. They also need rigorous testing and risk controls to prevent potentially harmful outcomes from their trading strategies, he said.

“All the software they develop, for the most part, is proprietary,” Dostellio said. “They’re trying to attract the best talent that’s out there because that’s their competitive advantage.”

U.S. Securities and Exchange Commission Chairman Mary Schapiro called Knight’s problem “unacceptable.” The agency will assess the need for additional regulations related to the so-called market access rule aimed at reducing the risk of trading disruptions, including from rogue algorithms and unsupervised executions, according to an Aug. 3 statement.

Risk Checks

The rule, adopted in 2010, directed brokers starting last year to employ credit and capital risk checks and filters to ensure a firm’s aggregate financial position doesn’t exceed its specified limits. It required brokers to have controls to avoid jeopardizing their own financial condition and the integrity of trading on U.S. securities markets.

The Managed Funds Association, a trade group for the hedge fund industry, said the SEC should re-evaluate the market-access rule in light of Knight’s mishap. Regulators should consider requiring brokers to employ risk controls on an order-by-order basis before trade requests are sent to a market, it said in a letter to Schapiro today. Brokers could also have a technology advisory group conduct risk assessments, it said.

‘Kill Switch’

At least one trading official should be authorized to operate a “kill switch” to turn off trading programs at all times, the hedge fund group said. The SEC may also want to issue guidelines requiring a technical manager to certify to the company’s executives that proper testing and “appropriate market simulations” were done and the broker has complied with its own policies for software installations, the group said.

The regulation also mandated that brokers have systems to prevent duplicative or erroneous orders from entering the market, and obey rules such as those prohibiting manipulative activity or requiring shares to be located for short sales, or bearish trades. The goal was to make sure orders are vetted before they’re sent to markets.

Knight’s episode underscores the challenges that Wall Street firms have faced updating and maintaining their computer systems. After Lehman Brothers Holdings Inc. collapsed in 2008, bankruptcy examiner Anton Valukas from law firm Jenner & Block LLP found that Lehman had “maintained a patchwork of over 2,600 software systems and applications.”

“The Examiner’s financial advisers ultimately requested access to 96 of the most relevant systems,” Valukas wrote in a report published in March 2010. “Many of Lehman’s systems were arcane, outdated or non-standard.”

Technology Staff

Goldman Sachs Group Inc.’s technology staff accounted for 27 percent of its employee base in 2010, up from 16 percent in 2000, Chief Financial Officer David A. Viniar told investors at a conference in February 2011.

Small technical changes can “trigger downstream effects” that spiral out of control, Rick Lane, chief technology officer at Trading Technologies International Inc., a Chicago-based company that offers an execution platform for derivatives markets, said in a phone interview.

Software alterations to accommodate new features or order types offered by exchanges must be rigorously tested and “run through the wringer” to make sure the systems operate properly, he said in a phone interview.

“When you throw your trading strategy into a sea of other trading strategies, there’s no way to perfectly understand the consequences,” Lane said. “Identifying and quickly quelling these scenarios when they happen is important. It’s surprising something like this could last potentially 45 minutes. The ability to quickly identify a problem and take action is where innovation is sorely needed.”

(Updates to add Knight comment in eighth and ninth paragraphs and fund group comments under ‘Risk Checks’ subhead.)
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