Few erroneous trades resulting from Knight Capitals
algorithmic error last Wednesday were cancelled because the US
Securities & Exchange Commission (SEC) deferred to earlier
rulemaking. Another SEC backed initiative might have further
limited the number of busted trades.
A national market system plan
proposed by US exchanges and the Financial Industry
Regulatory Authority (Finra) earlier this year attempts to
reduce the number of busted trades by allowing trading to
continue exclusively within moving price bands. The so-called
limit up limit down plan
pauses trading in a security for five minutes if trades are
attempted outside of a price band for 15 seconds.
James Overdahl, a former chief economist at the SEC and
current vice president of the securities and finance practice
at NERA Economic Consulting, said one virtue of limit up
limit down is that it helps promote trade certainty.
I think one idea behind limit up limit down is
that it can prevent you from getting to the point of triggering
a busted trade, Overdahl said. [The security] just
wouldnt trade beyond a certain moving range, which may be
outside of the bust range.
Limit up limit down would replace currently used
single-stock circuit breakers. Only six circuit breakers were
triggered as a result of the Knight Capital calamity, meaning
that any possible benefits of limit up limit down in a
busted trade deterrent sense would have been limited to those
While limit up limit down is still at the proposal
level, investors are thought to have benefited from increased
certainty over how the SEC treats erroneous trades. Although
Knight Capital lobbied SEC Chairman Mary Schapiro to cancel a
lot of its trades, the Commission refused in recognition of
issued in response to extraordinary volatility dubbed the Flash
The Wall Street Journal reported.
The SEC, in its
report on May 6 2010 volatility, observed that uncertainty
over broken trades could impact the willingness of traders to
provide liquidity when the market needs it most. Overdahl said
this could especially be the case for market makers.
Market makers often times have two legged positions
and they need to make sure if they complete a trade on one
side, they know the risk on the other, Overdahl said.
The concern is if [market makers] know they face the
possibility of holding an unacceptably risky position they
would be less willing to step-up during times of market
Another SEC rule,
finalised last year, aimed to prevent uncertainty resulting
from trading errors at the source. The rule requires brokers
and dealers with market access to adopt risk control systems to
prevent erroneous trades. The SEC is
investigating whether Knight Capital had properly assessed
the faulty algorithm before deploying it.
Knight Capital suffered a trading loss of $440 million
resulting from erroneous trades, and
agreed to sell $400 million in preferred stock to TD
Ameritrade, the Blackstone Group, Getco and Stifel Nicolaus
& Company, with Getco temporarily assuming many of
Knights market making duties.
Knight Capitals trading error follows Nasdaqs
offering of Facebooks shares and the BATS Global Markets
crash earlier this year, raising high-profile concerns over
high frequency trading and imperfect algorithms. An attorney,
preferring to remain anonymous, earlier told IFLR the
Nasdaq and Bats errors, while technological problems, had very
little to do with high frequency trading. The same might be the
case for what happened with Knight Capital.
This sounds like the kind of thing that could have
occurred in any trading system, Overdahl said. By
modern market standards, this happened in slow