Knight Capital crisis brings new push for rules on trading, technology, structure

August 6, 2012

By Nick Paraskeva

NEW YORK, Aug. 6 (Thomson Reuters Accelus) – The near-collapse of equity market maker Knight Capital after sending erroneous trades to the New York Stock Exchange last week is the latest in a string of errors causing heavy losses and disrupting markets. While smaller in dollar terms than losses from JPMorgan’s ‘London whale’ or UBS’ rogue trader, it is causing regulators to review firms’ compliance and controls over operational risks, and rules for restructuring of equity markets.

“The apparent trading error by Knight Capital Group reflects the type of event that can raise concerns for investors about our nation’s equity markets,” SEC chairman Mary Schapiro said on Friday. “I have asked SEC staff to accelerate ongoing efforts to propose a rule to require exchanges and other market centers to have specific programs in place to ensure the capacity and integrity of their systems”.Knight disclosed $440 million losses on unwinding the erroneous and duplicate orders in 140 stocks. The loss was half the firm’s market value and the stock fell 75% before recovering on Friday on rescue hopes. The firm said on Monday that a group of investors would rescue it in a $400 million deal that keeps the company in business but comes at a huge cost to its shareholders.

The company had said last week that although its capital base has been severely impacted, its broker/dealer subsidiaries were “in full compliance with their net capital requirements.” This has given rise to questions of how capital funds are allocated around the group, and the Commodity Futures Trading Commission has sent investigators on-site to review segregated client funds at the group futures commission merchants.

“This is yet another instance that highlights the need for reforms in market structure in the US” said NYSE CEO Duncan Niederauer on an earnings call Friday. “We have talked about this publicly that the growing fragmentation and uneven regulations across what is now hundreds of competing platforms continue to fuel a crisis of confidence among investors. It is just too hard for them to understand how markets work”.

Rules and controls

“While Wednesday’s event was unacceptable, I would note that several of the measures we instituted following the Flash Crash helped to limit its impact,” Schapiro said. These included circuit-breaker rules that halted trading on individual stocks that saw significant price fluctuations. The erroneous trade rules gave guidance to exchanges as to which trades could be broken, thus giving certainty to the marketplace.

“Under our rules we broke trades in a handful of the issues which were found to be clearly erroneous,” Niederauer said. “After carefully reviewing the trading issue with the SEC and other market participants, we validated the trades and the remainder of the issues as is mandated under our exchange rules.”

In November 2010 the SEC adopted rules preventing unfiltered market access. They require brokers with market access — including those who sponsor customers’ access to an exchange or alternative trading system (ATS) — to put in place risk-management controls and supervisory procedures to help prevent erroneous orders. The rules are in place, and became effective for broker dealer compliance in 2011.

“Existing rules make it clear that when broker-dealers with access to our markets use computers to trade, trade fast, or trade frequently, they must check those systems to ensure they are operating properly” Schapiro said. “And, naturally, we will consider whether such compliance measures were followed”.

Niederauer said there has recently been too much focus on “market microstructure incrementalism” and that he hoped the incident will get regulators to seriously address the wider issues of reliability and resilience of markets during periods of crises, volatility or aberrant behavior. “We should remember that we are here to serve the investors in the broader market, not individual participants or their business models.”

NYSE retail liquidity program

Also launched last week was the NYSE’s “retail liquidity program” (RLP). This aims to attract more retail order flow to NYSE, while providing price improvement that is not publicly displayed. This is being marketed as a “first-of-its-kind innovation that produces cost savings for individual investors through price improvement on retail equities trading orders within an exchange environment.” If NYSE were able to win back market share of retail order flow, this could be at the expense of automated traders such as Knight.

The RLP rule creates two new classes of market participants among NYSE members. They include Retail Member Organizations, which are eligible to submit certain retail orders to NYSE. The rule also defines Retail Liquidity Providers, who are required to provide potential price improvement for these retail orders, in the form of non-displayed interest that is better than the best protected bid or offer by at least $0.001.

Retail orders are limited to agency orders from a natural person provided no change is made to the terms. It excludes all orders that originate from a trading algorithm or other computerized methodology. Retail firms may use a routing algorithm to send an existing retail order to NYSE, provided they assure the order meets retail requirements. Firms must have policies and procedures to assure they will only designate an order as retail if the requirements are met, and the Finance Industry Regulatory Authority will review firm’s compliance with the requirements.

Knight CEO Joyce had earlier “urged the SEC to carefully study and analyze the sweeping implications” of the Retail Liquidity Program, “especially the impact on Reg NMS and the move to sub-penny quoting.” NMS rules prohibit market participants from displaying, ranking, or accepting quotations in NMS stocks that are priced in an increment of less than $0.01, unless the price of the quotation is less than $1.00.

“There has been some speculation in the media that this was somehow related to the launch of our RLP program,” Niederauer said. “So let me be clear in saying it had nothing to do with RLP. RLP enjoyed a successful launch with multiple market participants trading on the platform with no problems whatsoever.”

Technology testing

“Knight has spent the last 17 years evolving our technology infrastructure so that it can process millions of trades a day on behalf of the retail investor – in a fast, reliable, cost effective manner, while providing superior execution quality and service,” Knight CEO Tom Joyce said in June testimony to the House of Representatives. “We spend tens of millions of dollars every year making our technology platform better, faster and more reliable”.

Knight deals both with sophisticated institutions, and indirectly with retail customers through their brokers such as Scottrade, TD Ameritrade and Fidelity. In 2011, the firm executed 900 million equity trades (or 4 million per day with a notional value of $6.4 trillion ($24 billion per day), a huge multiple of its capital base.

“We strongly believe managing technological change must be an essential element of risk management for all market participants,” FINRA’s Principal Traders Group said in a statement on Friday. The FIA had in March 2012 issued recommendations on best practices for the tests and controls that trading firms should consider whenever they make changes to their technology systems.

The guidance recommends firms have a process to test software before its release. In addition to unit and acceptance testing, firms should consider ‘exchange-based conformance testing’ to confirm a system’s functionality in interacting with an exchange. This is guided by a script of tests provided by the exchange, and performed in an exchange-provided testing environment to simulate the actual trading environment.

“Technology specifications for the new [RLP] order type were out in October of last year,” Niederauer said. “We opened for user acceptance testing in January of this year, and this testing has gone on for months. And we sent notice of the official launch and a reminder of testing in the middle of July, and many market participants have tested with us during this period of user acceptance testing, including Knight in fact.”

The error came on the heels of NASDAQ technology problems on Facebook’s initial public offering in May, which Joyce called “highly dysfunctional.”

Reference Links

SEC Final Rules on Risk Management Controls for Brokers or Dealers with Market Access (Nov. 3, 2010)

NYSE Information Memo 12-19 on new rule 107C: Retail Liquidity Program (July 31, 2012)

Testimony by Knight CEO Thomas Joyce to the House Financial Services Committee (June 20 2012)


(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. <a href=” ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

(Nick Paraskeva is principal of Reg-Room LLC (, which provides regulatory information and consultancy. He covers various facets of the banking and securities industry and delivers exclusive analysis through Thomson Reuters. He can be contacted at (212) 217-0403 and Follow Nick on Twitter@regroom.)

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