[ by Melanie Gretchen ]

Will the SEC shed some light on Knight Capital Group's $458 million trading error?

More than 3 months after Knight flooded the U.S. stock markets with thousands of erroneous orders, which cost the firm some $462 million, the SEC has begun a formal investigation.  Federal examiners are assessing the firm’s compliance with a rule governing risk-control procedures in its trading operation and other regulations - that, according to a regulatory filing by the company.  Knight was reported that it was the subject of on-site examinations into its capital and liquidity conditions,.  Those inquiries have concluded.

Knight blamed the trading mishap on faulty software - though the facts and circumstances indicate that the problem largely can be attributed to the firm's decision - i.e., to be read as CEO Tom Joyce's decision - to operate a trading system that had not been adequately tested.  One should not lose sight of the coincidental timing of the trading mishap, which was August 1, 2012, the same day that the NYSE and its Amex stock markets launched their controversial Retail Liquidity Program that was expected to take order flow away from Knight and other market makers.  If such presumptions proved accurate, then it adds credibility to the theory that Tom Joyce was not ready to let the Exchanges "waltz into market makers' territory - at least, not without a fight or distraction.

SEC Objectives.   The SEC is examining Knight's compliance with the so-called market-access rule, adopted in 2010 to reduce the risk of trading disruptions and improper and manipulative activity.  The rule, which became effective last year, requires brokers to employ risk checks on orders before they’re sent to markets to make sure they aren’t erroneous and don’t exceed preset capital and credit levels.

Knight's erroneous orders caused the firm to build up securities positions of more than $7 billion, which when liquidated at distressed prices, resulted in trading losses of about $462 million.

The Aftermath. Since that fateful morning, which nearly put Knight out of business: 

• Knight was taken over by 6 Wall Street firms including Jefferies Group Inc. and Blackstone Group LP in August after losses associated with the computer malfunction depleted its capital.
• In September, the firm consolidated oversight of its finances and operations under a single executive and reassigned its technology chief.  [C-I Note: Knight CEO Tom Joyce has attributed the error to having improperly installing software that malfunctioned.]
• Knight has separated its processes for developing software and installing it to ensure they’re now done by different people, Mr. Joyce said.  It instituted more checks and balances to reduce the chance of a similar mistake occurring and implemented controls on systems that send orders to markets “so we can get to the router faster and stop it from creating problems sooner,” he said.
• CEO Tom Joyce is looking for employment elsewhere, although there's been nothing mentioned as to whether the decision was instigated by the 6-firm consortium or, if Mr. Joyce decided on his own to change corporate scenery.

What the SEC Could Do. Unfortunately, there is no "silver bullet" for technology malfunctions, James Burns, deputy director of the SEC’s division of trading and markets said at a conference in New York in September.  Going forward, he said the SEC is working on a proposal to convert guidelines from two decades ago about how exchanges manage their automated systems into a regulation.

"It was expected that the SEC would look into Knight’s operations.  There are rules in place that would presumably prevent these mishaps, but then again human errors do occur." -- Richard Repetto, a New York-based analyst at Sandler O’Neill & Partners LP, in a phone interview.

For further details, go to [Bloomberg, 11/9/12].