Knight Capital's Loss Ignites Demand For Intervention In Automated Trading System

Aug. 9.12 | About: KCG Holdings, (KCG)

Earlier, we saw how one of the biggest market makers in the New York Stock Exchange (NYSE), Knight Capital (NYSE:KCG), was hit by a software glitch that forced it to tell its customers that they needed to redirect their orders to its competitors until the situation was sorted. To add to its woes, initially many of the company's renowned customers did not resume trading with KCG even after the situation was resolved. The electronic trading system at KCG makes use of sophisticated technology to ensure that reliable and fast trades are processed. However, the system malfunction led to erroneous trades in more than 140 stocks on August 1, 2012. Stocks of few companies dipped, while others witnessed a significant surge. Besides disrupting the equity markets and the market maker incurring a loss of $440 million, the glitch in the company's newly installed market making software caused Knight Capital's stock to lose 75% of its value in just two days, bringing the company to the brink of bankruptcy. The company was saved from bankruptcy only after the successful sale of its convertible securities worth $400 million. It was not until Goldman Sachs (NYSE:GS) offered to support the company that the stock price rallied 57% to $4.05.

The entire episode, besides shattering the confidence of Knight Capital's customers, also raised questions about the reliance of automated trading systems. While Knight Capital heals from its self-inflicted wound, talks of weakened investor confidence and the "humans vs. machines" debate are the two themes being focused on right now. The benefits of the automated trading system are tremendous. Where automated trading has the benefits of processing millions of trades in a time span of just milliseconds, it also has its drawbacks. However, the benefits significantly outweigh the drawbacks; hence an end to automated trading systems seems unlikely. However, talks of reviving the human role in this regard are widespread. This is not the first time that such a debate has been triggered. Facebook's (NASDAQ:FB) IPO debacle and the 2010 flash crash are other examples where software bugs have caused significant losses and shattered investor confidence. Experts are arguing that regulators should create a mechanism where trading in a particular stock halts when either the stock's price or its trading volume moves beyond predetermined levels. These simple steps would help reduce the probability of such an event reoccurring in the future. The Securities and Exchange Commission (SEC) has been forced to write new rules regarding automated trading, and in this regard, the commission has called for a meeting in September. The meeting will to be to work on how the stability and structure of the markets should be preserved going forward. NYSE CEO Duncan Niederauer, in a statement, said that the NYSE had discovered an anomaly and contacted Knight Capital as soon as the market opened. However, the prevailing rules did not allow for any intervention in the stock exchange. The anticipated new rules will provide the stock exchanges greater capacity to intervene in case abnormalities are seen in trading volumes. The U.S. Congress has been called upon to examine whether such automated trading is damaging equity markets.

In conclusion, we believe that the technology bug in the market maker's automated trading system, which processed a daily average of $19.5 billion worth of trades in June this year, will demand for greater regulation and human intervention. Even though according to Thomas Joyce, the Chief Executive Officer of Knight Capital, the after-tax trading loss might be $270 million, we believe the company might suffer additional losses, as it has to pay more legal costs and witness decreased revenue. The company is expected to resume its operations as a designated market maker on August 13, 2012, according to a NYSE Euronext statement.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.