Sunday, August 5, 2012

Knight Capital Group, continued

The ongoing saga of Knight Capital Group continues to unfold.

Four full days have passed since whatever-it-was happened on Wednesday morning, and plunged Knight Capital into this severe crisis.

But there is still precious little information available about what actually happened, in detail.

Several articles that I've read attempt to shed some light:

  • In the New York Times, we read that many are still confused about why it apparently took Knight nearly 45 minutes to resolve the problem, once they learned of it: Trading Program Ran Amok, With No ‘Off’ Switch:
    Several market insiders said that they were bewildered, because in a market where trading losses can pile up in seconds, executives typically have a simple command that can immediately halt trading.

    “Even just a minute or two would have been surprising to me. On these time scales, that is an eternity,” said David Lauer, a trader at a high-speed firm until a year ago. “To have something going on for 30 minutes is shocking.”

  • An article from Reuters notes the dramatic shift of order processing away from Knight's sytems: Knight Capital heads into make-or-break weekend
    through Tuesday of this year, Knight accounted for 20 percent of the market making activity in shares of Apple, one of the most actively traded stocks on a daily basis. By midday Friday, Knight was the market maker for just 2 percent of the share volume
  • And multiple other articles are speculating that Knight Capital is on a very short lifeline, and might not even exist as a corporation by the end of the next 24 hours.

Of course, Knight themselves aren't saying much. I suspect we will have to wait until the SEC or some other organization performs a more detailed investigation to really learn the details.

In the meantime, though, what do we know about what actually happened?

We have a little bit of information from Knight's official press release, which you can find on the SEC web site KNIGHT CAPITAL GROUP PROVIDES UPDATE REGARDING AUGUST 1ST DISRUPTION TO ROUTING IN NYSE-LISTED SECURITIES. It's so short, it deserves listing in its entirety:

As previously disclosed, Knight experienced a technology issue at the open of trading at the NYSE yesterday, August 1st. This issue was related to Knight’s installation of trading software and resulted in Knight sending numerous erroneous orders in NYSE-listed securities into the market. This software has been removed from the company’s systems.

Clients were not negatively affected by the erroneous orders, and the software issue was limited to the routing of certain listed stocks to NYSE.

Knight has traded out of its entire erroneous trade position, which has resulted in a realized pre-tax loss of approximately $440 million. Although the company’s capital base has been severely impacted, the company’s broker/dealer subsidiaries are in full compliance with their net capital requirements. Knight will continue its trading and market making activities at the commencement of trading today. The company is actively pursuing its strategic and financing alternatives to strengthen its capital base.

CNBC reported some more details about what happened when Knight "traded out of its entire erroneous trade position": Goldman Sachs Priced Knight Unwind at $440 Million.

It was Goldman Sachs that helped Knight Trading Group to unwind its inadvertent purchase of 148 stocks on Wednesday


Goldman Sachs agreed to purchase Knight’s unwanted positions as part of one huge basket sale, the people familiar with the matter said, late on Wednesday. But the illiquid nature of some of the stocks and the urgency with which Knight wanted to sell the positions left the bank with plenty of negotiating power, added these people.

It's interesting that the press release terms this an "erroneous trade position", and the CNBC story calls it "Knight's unwanted positions". These terms make it look like the basic bug was that the software was buying stock that Knight didn't intend it to be buying, leaving Knight with a whole pile of unwanted stock.

If the error was entirely on the buy side, though, why were prices so volatile on Wednesday morning, and why was the volume so heavy?

Meanwhile, many have observed that it's highly significant that this event occurred on August 1st, which was apparently the date on which the NYSE's Retail Liquidity Program went into affect. On the Fortune web site, Stephen Gandel speculates about whether this was actually a coincidence or not Why Knight lost $440 million in 45 minutes:

Some say that market makers provide a service. Others say Knight and others seek out the orders of individual investors because they view those orders as so-called dumb flow and easier to trade against. What is clear is that Knight and others have figured out how to make money off the stock trades of you and me in ways that we can't detect but we probably pay for somehow. Eric Scott Hunsader, who runs trading research firm Nanex, estimates market makers have been able to generate $5 billion in profits rapidly trading the orders of individual investors and others in the past seven years.

On Wednesday, the same day that Knight lost $440 million, the NYSE launched its own computer driven trading system, called the Retail Liquidity Program, that the exchange hopes will reclaim some of the trading volume it has lost to market makers. NYSE hopes RLP will create more competition among traders and brokers and market makers so that more of those orders get filled at better prices on the exchange.

What is the Retail Liquidity Program? Well, here's what the NYSE themselves have to say about it in their press release:

"The Retail Liquidity Program is an attractive trade execution alternative for individual investors," said Joseph Mecane, Executive Vice President, NYSE Euronext. "Providing price improvement for retail orders within an exchange environment affords individual investors new economic incentives and ensures greater transparency, liquidity and competition throughout the U.S. cash equities marketplace."
I have no idea what that means.

The Wall Street Journal offers some more digestible information: What Exactly Is NYSE’s Retail Liquidity Program?

The NYSE proposal—called the “Retail Liquidity Program”—works along the same lines as the dark pools that trade large blocks of shares for institutions. Dark pools are private platforms set up for anonymous stock trading.

For example, if a doctor trading stocks from his home office wanted to sell 100 shares of Sirius XM Radio Inc. at the bid price of $1.85 a share, a tenth-of-a-cent improvement on the NYSE would see his order filled for $185.10, instead of $185.00.

Most of the Wall Street Journal information, however, is deep behind WSJ's paywalls, so I may never know what information they had to share.

After all this, I'm still left puzzled by what the software error was. Was it a poor user interface, that allowed some poor trader to make an enormous (but human) mistake, as in the famous "fat finger" explanation for the May, 2010 flash crash? Was it an error in the time execution of position-changing orders, or an error in the overall size of otherwise-valid orders, as various others have speculated?

I'd love to know, mostly because each time I learn about a software error, and how it was made, and how the testers didn't uncover it, I think some more about the errors that I make, and how to avoid them, and how to catch them, and how to ensure that they have, at worst, obvious, easily-diagnosable, and straightforwardly-repairable effects.

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