How Knight Capital increases SEC trade certainty

Author: | Published: 7 Aug 2012
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Few erroneous trades resulting from Knight Capital’s 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 wouldn’t 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 six stocks.

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 2010 rules issued in response to extraordinary volatility dubbed the Flash Crash, 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 stress.”

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 Knight’s market making duties.

Knight Capital’s trading error follows Nasdaq’s offering of Facebook’s 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 motion.”