Knight Capital's Surprise $7 Billion Bounty

Knight Capital's Surprise $7 Billion Bounty


AUGUST 09, 2012

After its new trading algo went rogue, the market maker held a jaw-dropping $7 billion in stocks - and had to unload almost half or they would collapse.

They say that people with OCD such as compulsive gamblers or shoppers often slip into fugue states where they go on their particular binge only to wake up to find the scale of what they had done. In the case of compulsive shoppers they will ask, 'Did I really buy all that?!'

Imagine how traders inside Knight Capital felt after they realized that their brand new trading algorithm that went live on August 1st had bought. Fortunately, the damage from the rogue algo was almost immediately apparent. According to a report in the Wall Street Journal, their runaway algo went on such an enormous buying spree that at one point the market maker owned nearly $7 billion in stocks on that fateful day last week.

What other high finance firms have crashed and burned? Check out Wall Street's 5 Biggest Tech Fails.

Seven billion dollars in stocks acquired in 45 desperate and apparently unstoppable minutes. In less than one hour, this second-tier investment firm - respected for its technology and strong leadership - became one of the largest trading firms on Wall Street.

While scrambling to shut down the runaway algo, traders inside Knight Capital also had to unload as much of the new stock it had unwittingly acquired as the allegedly untested trading algorithm did its damage. By the end of the trading day, the WSJ and Reuters report that the firm had reduced the spending spree tally down to a slightly less dire $4.6 billion.

According to Reuters:

The position led to a $440 million loss that forced Knight to secure a $400 million bailout from a group of independent investors in exchange for a 73 percent stake.

The exposure would have prevented the brokerage from opening for business the next day due to lack of capital required by regulators to offset risks from holding the stocks, the newspaper reported.

As the dust settles from the Knight Capital debacle, all eyes are on the technology used and ignored inside the market maker. Reports claim that the brokerage failed to have a "kill switch" in place and that the algorithm was untested. According to Reuters, a "spokeswoman for Knight also said that the brokerage had not reached a decision yet on an outside firm coming in to review the technology problem that drove the wayward trading... "

What must the traders inside of Knight been thinking? I wonder if a few lines from the Talking Heads song "Once In a Lifetime" came to their minds:

"What have I done? How did I get here?" Should I give my head a shake?

How long will it be before Major Canadian Banks algorithms obtain a mind of their own causing a major meltdown of  Canadian Stock trades as they out smart themselves and loose billions of dollars in minutes as their fail safe switches fail to work forcing them to amalgamate as their equity vanishes in a puff of smoke.

Knightmare on Wall Street

AUGUST 04, 2012

After losing $440 million in 45 minutes of trading Wednesday at the hands of erroneous automated trading software code, Knight Capital is fighting for its survival in what’s looking like a cruel twist of fate meted out by the automated market. With its future uncertain, Knight reportedly has opened its books to potential acquirers, including bulge-bracket firms.

Before this week, Knight was regarded as a powerhouse in electronic market making and institutional brokerage. But the firm’s so-called "Knightmare" started almost as soon as the markets opened Aug. 1. As trading unfolded, a faulty algorithm fired off millions of shares of erroneous orders and created havoc in 150 stocks routed to the New York Stock Exchange, rattling already weak investor confidence in the system. Early that morning, the company said it was having a “technical issue” on its listed market making desk that was affecting orders routed to the NYSE, adding that it had notified clients to route orders through other brokers. Even though Knight unwound the positions, and said no clients were harmed, some major retail customers — E*Trade, TD Ameritrade, Vanguard and Fidelity — routed their orders away from Knight, at least temporarily, curtailing revenue when Knight needed it most and complicating any potential acquisition of the firm.

According to today’s New York Times Knight rushed out a new system to participate in the NYSE’s new Retail Liquidity Provider program, without adequately testing it, though rival firms waited to take their time. The incident has raised questions about the electronic broker’s procedures for testing software and quality control and why it didn’t have a “a kill switch” to stop the out-of-control algorithm.

Live By the Sword, Die By the Sword

How quickly circumstances can change the fortunes of a successful trading enterprise in today’s high-speed ecosystem. The frenetic system is so complex and interdependent with 13 exchanges and 50 or more dark pools, that when these sudden disasters strike, humans seem unable to turn off the machines. Even though the NYSE traced the problem to Knight, it didn’t have authority to halt trading within the first 15 minutes of the opening. In a cruel form of justice, it was market participants hedge funds, individual traders at proprietary trading firms and asset managers with specialized algorithms that detected the abnormal prices and acted swiftly to punish Knight for its careless ways. In the absence of regulators to safeguard the market or mandatory standards to guide electronic trading, the market seemingly evened the score.

Since this is the third disaster involving electronic trading and flawed software in five months — it occurred on the heels of BATS’ halting its IPO in March due to a system glitch and Nasdaq’s technical problems with the Facebook IPO in May — on top of the May 2010 Flash Crash, even analysts and pundits who have vigorously defended the market’s reliance on high-frequency trading have begun to worry. Even they are acknowledging that the markets are too complex and too fragile to withstand these jolts. Still, out of fear that it would reduce profits or drain liquidity, the industry has resisted any proposal that would rein in computerized trading.

Better real-time technology could help regulators, contends David Leinweber, author of "Nerds on Wall Street: Math, Machines and Wired Markets" and the head of the Lawrence Berkeley National Laboratory Computational Research Division’s Center for Innovative Financial Technology. Writing yesterday in Forbes.com, Leinwebber called for “centralized real-time monitoring of markets, like the FAA does with air traffic.”

Fortunately, the SEC already is moving in this direction. But it has a long way to go. Last week, the SEC announced that it had licensed a high-speed market data research platform from Tradeworx, a high-frequency trading firm, to help the regulator oversee the equity and options markets. It’s also working on the larger, consolidated audit trail system. In the meantime, organizations like FIX Protocol Limited, whose buy- and sell-side members understand algorithmic trading, recently upgraded its risk control guidelines for brokers to prevent an errant algorithm or fat-finger mistake from blowing up the market, as Knight’s error did. And the SEC’s limit-up, limit-down rule for stocks is supposed to go into effect later this year, to help exchanges control abnormally wild price swings.

But tougher measures may be needed. After the Knight debacle, one buy-side trader said there could be calls for more regulation of algorithms. Obviously, no one wants to submit their Algorithms to a federal agency for testing, but safeguards clearly are needed. Otherwise, how can the market win back the confidence in investors, when even the professionals’ nerves are shot?

We say that if you are a player and play the game of spiders and bots then you deserve everything you get. Poorly written algorithm's will  be the death of many a player in the world financial markets as they get gobbled due to poor investment decisions and inferior software. Its the dawning of the day the Dinosaurs came out to play.