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No Kill Switch for Knight Capital

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August 07, 2012 – Comments (0) | RELATED TICKERS: KCG

Board: Macro Economics

Author: yodaorange

The Knight Capital (KC) situation is getting more interesting by the day. Tomorrow, Monday 8/6/12 is the day of reckoning for KC. All of the trades they did last Wednesday “settle”. This means that Knight has to come up with the $440 million in losses to pay off all of their bets. We will see.

The most often asked question about KC is” “Why did it take 45 minutes for KC to turn off the program that had the problem and stop the bleeding?” KC has been described variously as stupid, incompetent, etc for not hitting the red kill switch faster.

The best explanation I have determined so far actually paints KC in a rational light. At least as rational as a company can be that was losing $10 million per minute. A precursor is understanding two different types of trading.

1. Proprietary trading aka prop desk is where a company trades purely for their own account. Most high frequency traders are in the category. Their only mission is to make money for the firm. They have NO responsibility for any other party. If they unduly harm another party by some nefarious/questionable/immoral means, all the better. It is the other guy’s problem. If the company wants to turn off their HFT prop trading at any time for any reason, they have the right to do that. This is what happened in the May 2010 Flash Crash. KC’s bad computer program was NOT a proprietary HFT IMO.

2. A totally different type of trading is where a firm is a “designated market maker”aka DMM for NYSE listed stocks. This is the computer version of what NYSE floor specialists used to do. In the old days, if you wanted to buy an NYSE stock, you physically walked to the specialist station and placed your order. The specialist firm was selected by the NYSE for each stock. It was their responsibility to keep trading for that stock “orderly.” The specialist had the power/authority to stop all trading in a stock if things got out of control aka “imbalance.” The specialist bought, sold and sold-short shares for his own account in order to maintain order. The specialist’s goal was to buy small quantities of stocks and hold them for short periods of time, only as a last resort to keep the trading orderly. If there were enough outside buyers and sellers, the specialist did not/would not take any positions in the stock. The specialist was also responsible for managing the “book” which had all of the open buy and sell orders on it.

Fast forward to 2012. KC is the one and only DMM for many NYSE listed stocks. They have a contractual obligation to keep trading “orderly” on those stocks. They are NOT permitted to stop trading at any time for any reason. In 2012, the DMM role is played by a computer running in a HFT mode. The program is constantly monitoring all of the buy and sell orders. The program is supposed to act as the buyer and seller of last resort in order to keep trading orderly. The same program is probably used for all stocks that a DMM is responsible for. This appears to be the KC program that had the bug. The program bug was buying and selling, attempting to maintain orderly markets in the ~150 stocks affected.

It somehow got bid and ask prices backwards. Normally a specialist would buy at the bid price and sell at the ask price. Say a stock is trading at 25.00 bid and 25.05 ask. An outside investor would pay 25.05 to buy a share and could sell at 25.00 for a 5 cent per share loss.

The specialist would have the opposite side. He would buy at 25.00 and sell at 25.05 for a 5 cent per share gain.

In this case, it appears that KC’s program got the bid/asks reversed somehow. So they were losing the bid/ask spread on every share instead of profiting from it. And they were doing it at HFT speeds of roughly 200 times per SECOND per STOCK. Multiply that by ~150 issues and 45 minutes and you get a $440 million loss!

KC probably realized early on that they had a big problem. Unfortunately for them, since they were the DMM for a lot of those stocks, they did NOT have the option of hitting the red kill switch. It would have thrown the market into total chaos for those stocks with far worse implications.

For example, let’s assume that the KC program had all of the buy and sell orders for Vanguard, TD Waterhouse and Fidelity for a given stock. The small investor placed his order. Fidelity “routed” the order through KC where KC’s DMM program kept track of it. From the perspective of the investor and Fidelity all was well.

But what happens if KC hits the red kill switch? It would essentially cancel all of the open orders from all of the customers on all of their stocks WITHOUT notifying the brokerage or the customer. Talk about a nightmare of liability!

KC’s only alternative was to start notifying all of their customers (brokerages) that all open orders need to be cancelled and re-routed through a different market maker. This was an attempt to make an orderly wind down of the problem. And it took 45 minutes to do it.

You can imagine the KC management seeing this all unwind in front of their faces. And you can imagine the software group that released the new program. Not a pretty picture. However given the choices they had at the time, I think they did the correct thing by an orderly winding down of all open orders. And yes IMO, the firm will be wiped out due to this one error on one day. Pretty remarkable. I still think BK or buyout for KC is inevitable.

Eventually all of the details will come out, but for now, this is my best explanation that I have been able to piece together.

BOTTOM LINE: at this point, I do NOT have any actionable recommendations for individual investors. I am also NOT optimistic that anything will be done to prevent an accident like this from happening in the future. It is software and it is operating at very HIGH SPEEDS which is why you can have a nuclear meltdown in 45 minutes. In the old days of human specialist this NEVER would have occurred, but we are NOT going back to that state of the market.

Thanks,

Yodaorange

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