“Knight Capital’s Algorithmic Meltdown : Lessons learned from the $440 Million Loss”

By:- Niteksh

The American company Knight Capital Group offered institutional sales and trading, electronic execution, market creation,andotherglobalfinancialservices. With a market share of over 17% on the Nasdaq Stock Market and the New York Stock Exchange (NYSE), Knight was the largest trader of American stocks in 2012. Over 3.3 billion deals were executed on average every day by Knight's Electronic Trading Group (ETG), totalling more than $21billionindailytrading.

the first hour of trading, Knight purchased 150 different stocks for about $7 billion thankstothemalfunctioningsoftware.

Building Knight Capital Group into one of the top trading firms on Wall Street required 17 years of devoted effort. And in lessthananhour,itallalmostended. Every CEO's worst dread is what occurred to Knight Capital on the morning of August 1, 2012:The companywas in danger of failing due to a plain human error that was obvious in hindsight but practically challenging to detect beforehand. When the New York Stock Exchange (NYSE) opened that day, specific new trading software at Knight had a bug that wasn't discovered until after it was launched. In

The Dow Jones Industrial Average (DJIA) droppedapproximately1000pointsinjusta few minutes during May 6, 2010, Flash Crash, which prompted the SECto establish various new rules to control securities trading.First,circuitbreakerswererequired to halt trade if the market experienced "significantpricefluctuations"ofmorethan 10%throughout5minutes.Second,theSEC mandated more precise terms controlling transaction cancellation. Trades could be cancelledforeventsinvolvingfivetotwenty stocksiftheydeviatedmorethan30%from the "reference price," the last sale before pricing was disrupted. Trades could also be cancelled for events involving more than twenty stocks if they deviated more than 10% from the reference price. Third, the Securities Exchange Act Rule C.F.R. 240.15c3-5 ("Rule") became effective and mandated the implementation of risk management controls by exchanges and broker-dealers to maintain the integrity of their systems and executive evaluation and certification of the authorities. Few of the stocks Knight traded on that fateful day exceeded the 10% price change threshold; thus, the Flash Crash regulations, which were intended to stop trading based on price movements rather than trading volume,didnotfunctionasplanned.

Computer analysts at the NYSE saw that marketvolumesweretwiceashighasusual andlinkedtheincreaseinvolumetoKnight.

The NYSE then notified Knight's CIO, who convened the company's top IT personnel; in most trading companies, a kill switch in their algorithms would have been turned, or systems would have simply been shut down.It,therefore,struggledinthedarkfor another 20 minutes before concluding that the issue was with the new code. Knight had reverted back to the old code, which was still running on the eighth server and reinstalled it on the others because the "old" version purportedly worked. Even thoughthedamagehadalreadybeendone, night engineers discovered the cause after it had been deployed. They then shut off SMARS on all the servers. Knight had made over 4 million trades involving more than 397 million shares in 154 equities. It also assumed a net long position of about $3.5 billion in 80 stocks and a net short position of around $3.15 billion in 74 stocks. Most deals would stand and could not be cancelled since they were within the 10% price zone, as the NYSE's post-flash crash regulations required. That day, Knight's shares fell 33%, resulting in a mark-tomarket loss of more than $460 million for its trades. Other market participants may smell the blood in the water because news onWallStreetspreadsquickly.

Knight attempted to have the trades reversed. Mary Schapiro, the chairman of the Securities and Exchange Commission (SEC), made the proper choice by refusing to permit this for most of the stocks in question. After the "flash crash" of May 2010, guidelines were created to specify whentradesshouldbecancelled.Exceptfor six equities, Knight's buying spree did not cause the price of the purchased stocks to increase by more than 30%, the cancellation threshold. All of those transactions were undone. The trades were upheld in the other cases. This was terrible newsforKnight,butitwasonlysuitablefor its trading partners, who had willingly sold their shares to Knight's computers. Knight's deals were not like those made during the flash collapse when shares of some of the biggest firms in the world suddenly started tradingforaslittleasapenny,andnobuyer could feign that the price they paid for the stock represented its actual market worth. Knight was forced to sell all the equities it had purchased once it became apparent that the trades would stand. A big sale into the market would have driven the price of those shares down to a point where Knight would not have been able to cover the losses, just as the morning's rampant buyinghaddone.GoldmanSachspurchased Knight'sunwantedpositionfor$440million, a considerable loss but one the company might be able to bear. If Knight had failed, Goldman would have been the only entity harmedexceptKnight'sshareholders.

Selling the unintentionally bought shares was just the beginning of Knight CEO Thomas Joyce's fight to keep his business alive. Without a cash influx, the deals had severely depleted the firm's capital, forcing it to drastically scale back its operations or even shut down completely. Customers were also at risk of leaving the company if they didn't believe in its ability to manage its finances and operations as word of the software disaster spread. A week later, a groupofinvestorsgaveKnight$400million, andbythefollowingsummer,acompetitor, Getco LLC, had bought the company. This case study will go into the circumstances that led to the disaster, what went wrong andwhere.