FAQ: How has Knight Capital Group's software errors swayed regulation?

FAQ: How has Knight Capital Group's software errors swayed regulation?

Knight Capital Group lost $440 million in less than an hour due to faulty trading software. Regulators are now taking a closer look at how to prevent IT systems from causing future stock market upheaval.

The speed and complexity of software designed for high-frequency stock trading propelled Knight Capital Group's success in recent years, but those same properties drove the firm to the brink of bankruptcy. When New York Stock Exchange trading opened the morning of Aug. 1, 2012, a technology breakdown in Knight Capital's newly installed trading software caused a deluge of erroneous stock orders that severely disrupted the market. The new software had been deployed the day before, the company said, and it took about half an hour to halt the erroneous orders once the problem was discovered.

After Knight Capital Group lost $440 million in about 45 minutes of trading that day, regulators redoubled efforts to limit stock exchange damages inflicted by faulty technology. Specifically, they launched a review of the testing and control requirements needed to prevent highly complicated and interconnected IT systems from causing market upheaval when errors occur.

This FAQ is part of SearchCompliance.com's IT Compliance FAQ series.

Table of contents:

What did Knight Capital Group's erroneous trading activity cost the company?

Knight Capital Group was stuck with a $440 million trading loss after its software program swamped the market with erroneous orders. The firm teetered on the brink of bankruptcy for several days. Then, on Aug. 6, CEO and Chairman Thomas Joyce announced a $400 million equity financing agreement with a group of investors that included Jefferies Group Inc., The Blackstone Group LP, GETCO LLC, Stephens Inc., Stifel Financial Corp. and TD Ameritrade Holding Corp. Joyce said that the company's financial position and capital base were restored to a position that more than offset the loss caused by the software glitch.

The deal with the private equity and financial services firms ultimately saved Knight Capital Group, but at a huge cost to shareholders. Prior to the financing agreement announcement, the company's share price had dropped by approximately 70%. A class-action lawsuit has been filed against Knight Capital on behalf of shareholders.

The New York Stock Exchange temporarily revoked Knight's market-making responsibilities in the wake of the trading debacle, but reinstated them effective Aug. 13, after the company revealed its recapitalization plan.

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What compliance issues may have been violated during the Aug. 1 trading incident?

The Securities and Exchange Commission (SEC) is investigating Knight Capital Group's compliance with the agency's market access rule, which aims to protect the markets from algorithmic computer trading programs that fail to operate correctly. Firms are required to establish risk control systems to prevent trades from being made erroneously and to thwart orders that are higher than credit or capital limits.

After the Knight Capital Group's Aug. 1 trading disruption, SEC Chairman Mary Schapiro said that the commission would speed efforts to design a rule requiring exchanges to establish programs for ensuring the integrity of their computer systems. Knight's trading incident was "unacceptable," Schapiro said, but its impact was limited by a number of regulatory measures that had been put in place after the "Flash Crash" of 2010. The so-called circuit breakers adopted following that trading incident managed to temporarily stop the Aug. 1 volatile stock trading, she said.

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What compliance troubles did Knight Capital Group experience prior to the trading incident?

In 2002, Knight Securities L.P. paid $1.5 million to settle charges of market making and trading violations, including failing to honor posted quotes and accurately report trades, according to the National Association of Securities Dealers' Regulation subsidiary. (NASD later changed its name to the Financial Industry Regulatory Authority.) It was the largest settlement imposed by NASD Regulation for those types of violations. The company neither denied nor admitted to the charges.

In 2004, Knight (at that point called Knight Equity Markets L.P.) agreed to pay $79 million to settle fraud charges brought by the SEC. The SEC found that Knight had defrauded its institutional investors and censured the company for failing to reasonably supervise institutional sales traders. In addition to paying the monetary penalty, Knight agreed to hire an independent compliance consultant to review the company's policies and procedures for executing obligations, reporting trades and limiting orders, as well as its supervisory and compliance structure.

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What new regulations are being considered in the wake of Knight Capital Group's trading crash?

Regulators are looking at the role that system design and operation regulation could play in error prevention. In October 2012, the SEC convened technology and trading experts in Washington, D.C., to discuss best practices and systems used for generating and routing orders, matching trades, confirming transactions, and sending out information. While existing circuit breakers can stop single-stock trading when prices fluctuate too dramatically, regulators want to consider a broader type of circuit breaker that would stop all of a given market maker's orders.

Coming just a few months after Facebook's initial public offering was botched because of a technical error at NASDAQ, the Knight trading incident spurred a widespread reexamination of trading environment risk controls. As the Federal Reserve Bank of Chicago, or the Chicago Fed, pointed out, many trading firms do not follow risk control best practices, partly because those controls can slow orders. Given the highly technological nature of markets today, automated risk controls should be deployed at each stage of a trade's lifecycle, the Chicago Fed said. It suggested a number of controls that might have limited Knight Capital's financial loss, including capping the number of orders that can be sent to an exchange in a certain time period, deploying a "kill switch" to stop trading, and limiting the amount of money that can be lost.

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