Knight Capital Suffers US$440m Trading Loss from Software Glitch

Knight Capital Group said that it is “actively pursuing its strategic and financing alternatives”, after the financial services firm saw its shares plunge by up to 80% over two days. The fall resulted from a US$440m trading loss caused by a software glitch earlier this week, which wiped out much of the firm’s capital.

Problems with Knight’s trading software sent bogus, rapid-fire trades into the market for a period of 45 minutes on 1 August, leaving the firm with heavy losses on numerous stocks it bought at inflated prices. Many of its major customers, including TD Ameritrade, Vanguard and Fidelity Investments, stopped routing orders through the group, raising the prospect that the group will either be sold or face bankruptcy.

Commenting on the loss, Rik Turner, senior analyst, financial services technology at research group Ovum, said: “Discussion of whether technology has elevated risk in trading to unacceptable levels in the context of Knight Capital’s reported loss on account of a software glitch seems something of a red herring. First, because every company in the modern economy relies on software to run its systems. If a major supermarket chain such as Tesco has a major software problem that caused all its freezers to turn off in high summer, the loss from produce that had gone off would not cause debate as to the supermarket’s overreliance on technology, though it would probably have to explain to its shareholders why it didn’t have a decent monitoring system in place.

“Second, to argue that modern trading in the financial markets is overly dependent on technology suggests that there is an alternative, which there really isn’t. In a world in which liquidity is fragmented across multiple trading venues as is the case in New York and London, companies must rely on technology to enable them to achieve best execution for their customers, which in many countries is a fiduciary requirement.

“One could argue that the automation of trading, with software algorithms in servers effectively taking the buy and sell decisions based on their split-second analysis of market conditions, has increased risk as exemplified by the May 2010 Flash Crash in New York, but again, unless we are to revert to traders in funny-coloured jackets engaging in open outcry on the floor of the exchange, which would be akin to reverting to horse-drawn carriages, the software is here to stay. The challenge is to monitor and manage its performance and to deploy circuit breakers for exceptional circumstances like that when the market goes crazy.

“Knight Capital’s shareholders should certainly be asking about monitoring systems for the company’s software, not to mention its insurance policies against operational risk,” he concluded.

Analysis

The recent falls in the share price of Knight Capital with peak falls of 33% and 63% over the past two days were the result of the trading firm exiting erroneous trades caused by an algo trading software glitch that caused chaos on the wider market. The technology problems have cost Knight $440 million to unwind.

The volatile price movements in shares mid-week forced NYSE Euronext to review 140 trades, many of which are likely to have been corporate trading instructions, and eventually cancel six, with Knight Capital blaming a “technology issue” for the confusion and illogical trades that threw the markets, and have cost the firm $440 million to exit and in adverse share movements.

The chaos on the financial markets mid-week mirrored the famous flash crash of 2010 when automated algo trading systems run amok.

In a prepared statement yesterday Knight Capital said: “As previously disclosed, Knight experienced a technology issue at the open of trading at the NYSE August 1st. This issue was related to Knight’s installation of trading software and resulted in Knight sending numerous erroneous orders in NYSE-listed securities into the market. This software has been removed from the company’s systems.

“Clients were not negatively affected by the erroneous orders, and the software issue was limited to the routing of certain listed stocks to NYSE.

“Knight has traded out of its entire erroneous trade position, which has resulted in a realised pre-tax loss of approximately $440 million. Although the company’s capital base has been severely impacted, the company’s broker/dealer subsidiaries are in full compliance with their net capital requirements. Knight will continue its trading and market making activities at the commencement of trading today. The company is actively pursuing its strategic and financing alternatives to strengthen its capital base.”

Understandably the US Securities and Exchange Commission (SEC) has said it will look into the issue, saying it is “closely monitoring the situation and in continuous contact with NYSE and other market participants”. 

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