Knightmare on Wall Street?
The trading firm Knight Capital recently rushed to develop a computer program so it could take advantage of a new Wall Street venue for trading stocks.
But the firm ran up against its deadline and failed to fully work out the kinks in its system, according to people briefed on the matter. In its debut Wednesday, the software went awry, swamping the stock market with errant trades and putting Knight’s future in jeopardy.
The fiasco, the third stock trading debacle in the last five months, revived calls for bolder changes to a computer-driven market that has been hobbled by its own complexity and speed. Among the proposals that gained momentum were stringent testing of computer trading programs and a transaction tax that could reduce trading.
In the industry, there was a widespread recognition that the markets had become more dangerous than even specialists realized.“What is starting to become clear is that the costs in terms of these random shocks to the system are occurring in ways that people never anticipated,” said Henry Hu, a former official at the Securities and Exchange Commission and a professor at the University of Texas in Austin.
Knight, founded in 1995, is a leading matchmaker for buyers and sellers of stocks, handling 11 percent of all trading in the first half of this year, according to the data firm Tabb Group. Knight lost three-quarters of its market value in the last two days, in addition to losing $440 million from the errant trades, and was scrambling to find financing or a new owner.
While the turbulence on Wednesday hit scores of individual stocks, the broader market took the spasm in stride, closing down less than 1 percent on Wednesday and Thursday. The S.E.C., which has opened an investigation into potential legal violations at Knight, said it was “considering what, if any, additional steps may be necessary.”
Some S.E.C. officials are pushing new measures that would force firms to fully test coding changes before their public debut, according to a government official who spoke on the condition of anonymity. While the idea has long been discussed at the agency, it gained traction after the Knight debacle.
The S.E.C. applied limited safeguards on trading after the “flash crash” of 2010 sent the broader market plummeting in a matter of minutes. But big investors like T. Rowe Price, members of Congress and former regulators said Thursday that the S.E.C. and the industry had been too complacent and needed to do more to understand and control the supercharged market.
“Things are happening far too regularly,” said Ed Ditmire, an analyst at Macquarie Securities who focuses on stock exchanges. “It’s not nearly as solid a market as it should be, so there’s plenty of room for improvement.”
Arthur Levitt Jr., a former chairman of the Securities and Exchange Commission, said that recent events “have scared the hell out of investors” and called for the agency to hold hearings.
“I believe this latest event was handled better than the flash crash, but the larger question is whether our markets are adequate to deal with the technology that is out there,” Mr. Levitt said. “I don’t think they are.”
Regulators have made changes to the markets over the last two decades that have taken it out of the hands of a few New York institutions and allowed dozens of high-frequency trading firms and new trading venues to dominate the stock market.
The high-speed firms like Knight, which connect directly to the servers of the exchanges and are capable of executing thousands of trades a second, are responsible for more than half of all activity in American markets. Companies that have benefited from the fragmentation and computerization of the markets have largely managed to fend off tighter controls by pointing to the steady decline in the cost of trading stocks.
Some large, institutional investors, like Vanguard, have said that the increased volume of trading has made it easier to get in and out of stocks, lowering the ultimate costs for individuals who invest in popular vehicles like mutual funds.
But even people who had previously defended the advances in trading technology said on Thursday that too many problems had been overlooked.
In Knight’s breakdown on Wednesday, as well as in the botched initial public offerings of Facebook in May and BATS Global Markets in March, the problems were caused by new computer programs that had not been adequately tested. Currently regulators have no protocol for signing off on new software programs like the one Knight rolled out.
“When they put these things out in the world they are really being tried for the first time in a real-life test,” said David Leinweber, the head of the Center for Innovative Financial Technology at the Lawrence Berkeley National Laboratory. “For other complex systems we do offline simulation testing.”
Mr. Leinweber has suggested to the S.E.C. that it do this work with the help of the supercomputing facilities at his center. The S.E.C. has recently moved in this direction by contracting with a high-speed trading firm that will provide it with more up-to-date market information.
Other changes to the markets would help slow trading during crises. Before computer trading became dominant, if a flood of unusual orders came in, they would usually be questioned by human order matchers, called specialists, working on the floor of the New York Stock Exchange.
To mimic that role, regulators are introducing a circuit breaker called the “limit up, limit down.” This forces a pause in trading of a stock if it starts occurring outside a normal price range. The mechanism will start in February.
“Quite literally, it could have stopped the flash crash,” said Gus Sauter, the chief investment officer at Vanguard.
The S.E.C. did introduce some circuit breakers after the flash crash but they stopped trading in only five of the stocks that were hit by Knight’s faulty program.
Some critics of the current market structure have said that much bolder reform is needed. One change that has been contemplated is a financial transaction tax, which would force firms to pay a small levy on each trade. At the right level, this could pare back high-frequency trading without undermining other types, supporters say.
“It would benefit investors because there would be less volatility in the market,” said Representative Peter DeFazio, a Democrat of Oregon. He introduced a bill containing a financial transaction tax last year.
Opponents of such a levy say that it could hurt the markets and even make it more expensive for companies to raise capital.
“I would be very concerned about unintended consequences,” said Mr. Sauter.
But Representative DeFazio, who favors a levy of three-hundredths of a percentage point on each trade, says he thinks the benefits of high-frequency trading are overstated. “Some people say it’s necessary for liquidity, but somehow we built the strongest industrial nation on earth without algorithmic trading,” he said.
Similarly, Jeff Cox of CNBC reports, 'Knight-mare': Trading Glitches May Just Get Worse:
The Knight Capital trading fiasco, bad as it is, looms even worse because similar high-speed trading problems are likely to keep on roiling the markets and fueling investor mistrust.
Anger and gloom swept across trading floors Thursday, the day after the New York-based trading firm reported a software malfunction that caused a surge in volume at the market open Wednesday and violent price swings for nearly 150 stocks.
Few if any were cheering the misfortunes of Knight (KCG), whose very survival is challenged by the scandal.
But the biggest concerns were for the retail investors who are likely to continue to flee the market.
"You can only assume that these glitches are going to continue into the future," says Todd Schoenberger, managing director of the BlackBay Group in New York. "This is a huge, huge negative. It's another black eye for Wall Street. This is not good for the retail investor. How are they supposed to trust what we do?"
Knight blamed the malfunctions on a software upgrade and said the episode would cost a whopping $440 million, a burden that will force the company to raise capital to cover.
The price tag on a market that already had been bleeding investor money is yet to be determined.
"So many good people are getting hurt in a very bad way, so many people in many industries. This hurts all of us," says Sal Arnuk, partner at Themis Trading, an independent brokerage in Chatham N.J. "It hurts folks like us because when confidence is diminished people pull their money out of the market. When people pull their money out of the market my customers - institutions, mutual funds - trade less."
Indeed, investors have been taking their money out of equities and putting it into bond funds for most of the last three years, a situation that has been particularly acute since the Flash Crash of May 6, 2010. That event also was blamed on high-frequency trading and saw the Dow industrials lose nearly 1,000 points in a few minutes before recovering.
Similarly, the stock market bounced back Wednesday, but the smell of more trading chaos filled the air.
"Diminished commissions affect all brokers," says Arnuk, co-author with his partner, Joseph C. Saluzzi, of Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio (FT Press, 2012). "Trust me, we take no glee in watching these events unfold time and time again. Certainly, we don't benefit from the misfortune of our brothers in the industry."
Knight is a large player in the business, handling about 15 percent of the daily trading volume on the New York Stock Exchange, but is largely unknown outside of the HFT sphere. The irony of its current situation is acute: The firm's slogan is "The Science of Trading, the Standard of Trust," and its trading floor figured in heavily during the movie, "Wall Street 2: Money Never Sleeps."
Market pros wondered about the firm's future, both because of the capital hit it will take as well as the public relations nightmare that likely will persuade clients to take their business to other firms.
"They just took a huge capital hit. All of a sudden you have to constrain a lot of your trading activities," says Michael Cohn, a former specialist on the NYSE and now chief market strategist at Atlantis Asset Management in New York. "They're basically going to have to sell a stake in themselves in order to get back to where they were in terms of freedom to trade."
Ironically enough, Cohn and others mostly praised Knight for the way it handled the situation, coming clean both to clients and at the exchange about its problems.
"They were very smart in just saying 'cover.' They didn't try and trade out of the position," Cohn says. "What you do is you basically cut off a position so it doesn't do any more damage. But what happens is whoever is providing capital to them has been spooked."
"Knight responded admirably. They let their customers know that clearly technological glitches happen. They didn't cry. They're falling on their sword, but truly it is a sword. They're going to be hurt," Arnuk adds. "I don't want to fuel speculation as to whether Knight will make it or not. All I can say is I hope they do."
Market veteran Art Cashin, the head of floor operations at the NYSE for UBS, said the growth of other trading platforms has made it more difficult to catch high-frequency mistakes.
"None of the trades that occurred during the Flash Crash had to be canceled" at the NYSE, Cashin told CNBC. ""If we were still the vastly dominating trading force then you would have been able to stop it completely and quickly."
With Knight's survival an open question - the stock is off more than 70 percent from its Wednesday open - the broader issue may be what actions might finally be taken to address the HFT problems.
Traders who trumpeted the market's automation are now calling for more humans to be involved who might have flagged the bad Knight trades.
"At the end of the day this could swing the pendulum toward more human interaction in the markets, more traders on the floor," says Dave Lutz managing director of trading at Stifel Nicolaus in Baltimore. "This is absolutely going to result in some changes."
The high-speed trading arms race being waged on Wall Street has finally claimed its first major casualty.
Knight Capital Group, a brokerage that handles nearly 11% of all stock trading in U.S. companies, is in danger of collapsing after a software glitch triggered millions of unintended orders. The New Jersey firm lost $440 million in less than an hour — nearly four times the company's profit last year.
The blunder, which Knight's chief executive said on television was "a bug, a large bug" in its computer systems, caused Wall Street to shudder. Major clients including Vanguard Group, E-Trade and TD Ameritrade, which rely on Knight to fill orders for retail investors, pulled their business on fears that the damage isn't over. Leaders of the embattled brokerage scrambled Thursday to find rescue funding or even a buyer.
But, more broadly, the debacle highlights concerns on Wall Street and in Washington about structural flaws in the U.S. financial system. Observers are worried that the reliance on computer-driven trading, where stocks are bought and sold in the blink of an eye, could lead to a major equities meltdown.
"The ghosts in the machine have gotten out of control," said Larry Tabb, chief executive of Tabb Group, a financial research and advisory firm. "There are increasingly more problems and we haven't been able to get this right."
Knight's software executed in a matter of minutes a series of trades that were designed to be done over a period of days. This glitch is just one of a series that have plagued Wall Street in recent years.
In May, the Nasdaq Stock Market botched Facebook Inc.'s initial public offering. The latest glitch is also an echo of the 2010 "flash crash" that terrified investors after high-speed trading went haywire and $1 trillion vanished from the stock market.
In Washington, Knight's trading disaster has rekindled worries that new regulations haven't been effective in protecting investors.
Regulators and key lawmakers were looking into the situation Thursday, underscoring broad concerns about the stability of equity markets. The Securities and Exchange Commission briefed Democratic and Republican staff members of House and Senate committees that oversee the financial industry.
"While the committee is alert to extraordinary or abnormal market events, it is important for us to gather all the facts before determining a course of action," House Financial Services Committee Chairman Spencer Bachus (R-Ala.) said.
Rep. Maxine Waters (D-Los Angeles), the top Democrat on the panel's subcommittee that oversees capital markets, said she was very concerned about the volatility triggered by Knight. She supports hearings on the broader effects of the incident and other recent trading troubles.
"Like the problems with the Facebook initial public offering, events like this only further serve to undermine investor confidence in the markets," Waters said. "Though we don't yet know exactly what caused the problem with Knight Capital, with a drumbeat of financial market snafus continuing, it's clear that the industry, with guidance from regulators, needs to strengthen their internal controls."
Indeed, investors have stuck mostly to the sidelines after suffering crippling stock losses during the financial crisis. Many people have steered clear of sinking money into stocks, worried that big institutional investors and their high-speed tools can manipulate the market.
Knight's losses reaffirmed Los Angeles retiree Robert Altman's decision to pull nearly all of his investments out of stocks. Altman said his distaste for the market's wild swings and technical glitches may confirm industry fears that recent Wall Street technical mishaps could scare off retail investors.
"I'm out of it," said Altman, 73, who has plowed his savings into municipal bonds. "The little guy has no business in the market anymore."
Former Sen. Ted Kaufman, a vocal critic of high-frequency trading and how Wall Street has evolved, criticized Congress for denying the SEC adequate funding to do its job. He said post-"flash crash" regulations — even those that have yet to take effect — fail to address the larger structural problems on Wall Street.
What was once a duopoly of two major exchanges, the New York Stock Exchange and the Nasdaq, has evolved into more than a dozen separate trading platforms. There are also numerous "dark pools" where hedge funds and other large investors trade out of public view — what Kaufman likened to the Wild West.
"This is like a volcano that keeps sending out signals," said Kaufman, a Democrat from Delaware who is now teaching at Duke University's law school. Wall Street keeps sending out warnings like Knight's loss, he said, "and we're not doing anything about it."
Although the trading did not cause widespread turmoil in the financial system, it has threatened Knight Capital's very existence. Its stock has plummeted. On Thursday, Knight shares fell $4.36, or 63%, to $2.58. They dropped 13% more in after-hours trading.
Knight Capital is a key behind-the-scenes company that played an enormous role in the stock market's boom and bust in the dot-com era.
Known at the time as Knight/Trimark, the company rose to prominence in the late 1990s by handling the trades of individual investors who flooded into the market in that period. Though less visible than online brokers such as E-Trade and Ameritrade, Knight executed the swarms of orders that the brokerages funneled to it.
The brokerage operates a cavernous trading floor from its headquarters in gritty Jersey City, N.J., across the Hudson River from Wall Street, that has been a favorite of Hollywood movie makers. Its trading floor served as the backdrop for Oliver Stone's "Money Never Sleeps," the sequel to "Wall Street."
Kenneth Pasternak, who co-founded and once ran Knight, did not think the firm's loss would be fatal (he suggested Knight's post-tax loss could be closer to $250 million), nor did he think its losses exposed a major structural problem in U.S. financial markets.
Regulators and the industry may need to require better oversight of technological risks, much like auditing and management protections put in place to guard against frauds and trading losses caused by humans, Pasternak said.
What happened at Knight could easily be prevented in the future, he said. "It's part of the maturation process," as automation on Wall Street evolves, Pasternak said. "It's an immaturity that can easily be cured."
Regulators said they are closely examining Knight's trading loss.
The SEC said it is considering what additional safeguards the market might need to prevent similar losses in the future. Meanwhile, the Financial Industry Regulatory Authority, Wall Street's self-regulatory body, said it had examiners at Knight Capital and the firm was "in compliance with net capital requirements."
Knight, for its part, said it removed the problematic software from its systems Thursday. A spokeswoman did not respond to a request for comment.
One of Wall Street's biggest critics when it comes to high-speed trading, Joe Saluzzi, said it was only a matter of time before another glitch throws the market into turmoil.
"Everyone is at risk," said Saluzzi, a partner in the brokerage firm Themis Trading. "There's no doubt it will happen again. It's just a matter of how severe it will be next time."
There is no doubt in my mind either. It's only a matter of time before the next high-frequency trading meltdown but hopefully by then the damage will be contained.
By the way, among the top institutional holders of Knight Capital Group (KCG), you will find familiar names like Fidelity, Blackrock, Wellington and Vanguard, all clients of theirs (click on image to enlarge):
These fund managers just took a bath on this holding but something tells me naked short sellers profited big time off Knight's woes and its share price will bounce back (for high risk speculators only!). R.J. O'Brien, Citadel and Peak 6 are among the 'white knights' looking to buy the firm (Update: Goldman helped Knight unwind its $440 million error).
As far as the broader implications of high-frequency trading glitches, regulators and investors should be very worried. I see whacky movements in stocks every single day. Used to be once a week, now it's every day.
And this isn't just scaring retail investors away, it's also scaring institutional investors away. One of the reasons why pension funds are moving assets into private markets (private equity, real estate and infrastructure) is that they're concerned with extreme volatility in public markets and want to have more control over their investments.
Ironically, some pension funds are investing in hedge funds that engage in high-frequency trading and even front-run pensions on trades! Pensions also lend stocks to hedge funds that are actively shorting their own long positions and pay 2 & 20 in fees for this alpha! Admittedly, it's a bit more complicated than how I'm describing it but I'm not far off.
At the end of the day, the integrity of markets is paramount. If investors feel there isn't a level playing field, they will stop investing their hard earned money in the stock market. Nobody wants to fall victim to an algorithmic trading glitch, especially not retail investors suffering their own 401(k) nightmare.
Below, Chester Spatt, former chief economist at the SEC, Douglas Kass, Seabreeze Partners Management, and Irene Aldridge, ABLE Alpha Trading, discuss whether high speed trading is killing confidence and threatening the long-term health of markets. Good discussion, well worth listening to.
And Bloomberg's Mike McKee reports on how today's better-than-expected jobs report offers no reason for the Federal Reserve to take action to stimulate the U.S. economy. Barring any more trading glitches, this report will propel stocks higher.