3 Aug 2012

US brokers Knight Capital lose $440m on zombie trading

45 minutes of rapid-fire bogus computer trades cause Knight Capital’s shares to plunge by 75 per cent, and further undermines confidence in the ability of technology to drive stock markets.

Dozens of New York Stock Exchange securities went into spasms – some swung as much as 151 per cent in two days – before Knight managed to trade its way out of its erroneous positions, leaving it with a pre-tax loss of about $440m.

The price of some 150 shares were affected, from giant General Electric to small Wizzard Software Corp – whose shares soared from $3.50 on 31 July to $14.76 on 1 August.

Knight blamed the erroneous trades on a software malfunction and said no clients were affected, but Knight itself was left teetering on bankruptcy today.

The New Jersey-based company lost almost four times last year’s earnings in just two days when the computer glitch on 1 August resulted in rogue robots firing off trades to the stock market for 45 minutes without human intervention.

As a result, Knight’s only hopes for survival appeared to be a financial injection or a suitor to stave off financial collapse.

“You may be able to secure some emergency funding to hold them off before a buyer can come in. That’s the game plan for Knight right now,” said Matthew Heinz, a St. Louis, Missouri-based analyst at Stifel Nicolaus & Co.

The buck stops with Knight

Knight is a “market maker”, a matchmaker for buyers and sellers of stocks which handled 11 per cent of all trading in the first six months of 2012, according to data firm Tabb Group.

Knight Chief Executive Officer Thomas Joyce stressed that none of Knight’s clients suffered losses.

“Nobody except for us was wounded,” Mr Joyce said in a television interview yesterday, noting the wounds were self-inflicted.

“We put in a new bit of software the night before because we were getting ready to trade the NYSE’s Retail Liquidity Programme (RLP). This has nothing to do with the stock exchange. It had to do with our readiness to trade it. Unfortunately, the software had a fairly major bug in it. It sent into the market a ton of orders, all erroneous.”

Most of the 150 stocks affected were smaller issues such as Molycorp Inc, which usually sees about 2.65m shares traded daily. On Wednesday, more than 5.7m Molycorp shares traded in the 45 minutes after the opening bell, volleying the stock price between $17.50 and $14.35.

It is the third major technical glitch in the US markets in five months after Facebook’s botched initial public offering and the spectacularly failed Bats Global Markets IPO. Hardly reassuring for an equity market still haunted by the May 2010 computer stock trading crisis known as the “flash crash” when the Dow Jones Industrial Average dropped 1,000 points, about 9 per cent, before recovering minutes later.

RLP: the ghost of ‘flash crash’?

The NYSE expects to activate its Retail Liquidity Program on 1 August, allowing Knight and other market makers to offer retail investors stock prices that are fractions of a penny better than the market rate. RLP mimics the operations of dark pools – trading systems that let investors anonymously buy or sell larger blocks of stock without tipping their hand to a wider market.

Knight’s software glitch has now thrust the NYSE’s RLP plans into the limelight, however, and raised concerns about the ability of computers to manage complex data. Stock markets are increasingly dominated by sophisticated high-speed trading systems that aren’t necessarily compatible or error-free.

“You’ve got 13 exchanges, 50 dark pools, brokers that internalise client orders at their own desks and thousands of algorithms pumping orders in milliseconds,” Larry Tabb, founder of Tabb Group, a financial consulting firm, told the Chicago Tribune. “The structure just may be too complicated to work.”

Nasdaq glitch

The May 2010 ‘Flash Crash’ illustrates how quickly technical problems can accelerate.

Similar technical errors have spooked the market in recent months. Nasdaq computer errors were blamed for the Facebook IPO flop in which traders did not know whether they had bought or sold stock. And traders are still reeling by the spectacular failure of Bats Global Markets IPO in which investors watched share prices plunge below a penny on their first day of trading because of a computer glitch.

While the number of technical problems increase, market participants are increasingly coming under pressure to decrease expenditures – including technical costs – as trading margins narrow and regulation costs increase.

Dark Knight?

“They [Knight] have about 48 hours to shore up confidence,” James Koutoulas, head of an advocacy group for former customers of failed brokerages MF Global and Peregrine Financial, told The Guardian.

Knight is in talks with Silver Lake Partners-backed trading firm Virtu Financial LLC about a possible rescue deal, The Wall Street Journal reported and Knight has approached JPMorgan Chase & Co and Bank of America for financing, according to several financial media reports. CLSA Credit Agricole Securities said bankruptcy was possibile if Knight failed to get financing.

“Maybe this is the new chapter for programme trading and algorithm trading. We’ll have to go back and re-evaluate,” Tim Hartzell, chief investment officer at Houston, Texas-based Sequent Asset Management LLC, said.

Investors hold $375m of Knight convertible notes and can demand repayment if there’s a “fundamental change,” including a sale. The biggest owners of Knight’s notes are Goldman Sachs, Oaktree Capital Management, Invesco Ltd. and Citadel Advisors LLC, according to data compiled by Bloomberg.