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Knight Capital: A prelude to electronic trading Armageddon?

This morning I hear the news of Knight Capital, a market maker and electronic executer for many large clients such as Vanguard, Fidelity and TD Ameritrade, which are the no 1 in funds and brokerage in US, suffered a $440 mil trading loss due to a software glitch:

As one of the leading market makers in U.S. stocks, Knight is among the firms that are critical to smooth, orderly trading. Market makers match orders from buyers and sellers and often provide liquidity by stepping into the market themselves.

The speed at which Knight has unraveled has been particularly unnerving for investors and markets. It resulted from problems with the firm’s trading software that sent bogus, rapid-fire trades into the market for 45 minutes on Wednesday and left Knight with big losses on numerous stocks it bought at inflated prices.

Knight is in talks with Silver Lake Partners-backed trading firm Virtu Financial LLC about a possible deal, according to The Wall Street Journal. Knight has approached JPMorgan Chase & Co for financing, according to a report on Fox Business Network. A spokesman for JPMorgan declined to comment. Spokeswomen for both Knight and Silver Lake also declined comment.

Knight’s $440 million trading loss has reignited debate over whether technology has elevated risk in trading to unacceptable levels.

The U.S. Securities and Exchange Commission on Thursday said it would consider whether new measures might be necessary to safeguard markets.

"We continue to closely review the events surrounding yesterday’s trading and discuss those events with other regulators as well as Knight Capital Group," said SEC spokesman John Nester.

"We also are considering what, if any, additional steps may be necessary, beyond the post-Flash Crash measures that limited the impact of yesterday’s trading," Nester said.
Advocates of trading systems that can pump thousands of shares across Wall Street in milliseconds say the fault lies not in the systems but in the lack of controls at individual firms. Knight blamed its technology breakdown on new software that routed a flood of erroneous orders to the New York Stock Exchange on Wednesday, but offered no explanation as to why traders didn’t immediately intervene to arrest the obvious errors.


Trading veterans say the sprawl of trading venues in the United States coupled with the constant tinkering with software codes and systems upgrades have led to such complexity that disasters are bound to occur. Since March, a series of embarrassing technology issues, including the botched Facebook trading debut after its IPO and the failed public offering of BATS Global Markets have rocked markets and shaken the confidence of investors.

"You’ve got 13 exchanges, 50 dark pools, brokers that internalize client orders at their own desks and thousands of algorithms pumping orders in milliseconds," said Larry Tabb, founder of Tabb Group, a financial consulting firm. "The structure just may be too complicated to work."

But some experts fear that a regulatory and populist backlash — let alone protests from competitors — will reverse advances that benefit investors.

"I’m very worried people will take a look and say there is something fundamentally wrong with the market, and there isn’t," said Maureen O’Hara, a finance professor at Cornell University who sat on an advisory panel that explored reforms after the U.S. stock market collapsed inexplicably in a few minutes in the 2010 "Flash Crash."

Honestly not sure if you guys are scared about this. Perhaps because I am a bit of a techie and when you watch YouTube shows like TechSnap which weekly talks about security exploits such as stuxnet, it looks like we might one day head for another 1987.

It may present opportunities for the value investor point of view. You get to buy fifty cent dollars.

But for traders the fall out could be catastrophic.

Imagine you are risking $10,000 to earn $900 using an iron condor, which is a delta neutral options strategy basically betting the underlying will close in range with a 68% , 80% or 90% confidence.

One glitch like this will wipe off your $10,000 capital. No doubt price could return, but if you had a mechanical loss cutting mechanism you would have been killed.


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