Knightmare in the Financial Markets

Knight Capital's announcement today that it lost $440 million yesterday (Wednesday, Aug. 1, 2012) when its trading system went haywire illustrates the potentially dramatic consequences of computerized trading. Details on exactly what happened remain scarce. But it appears that trading volume at Knight spiked for some 30 to 45 minutes at many strange prices. A large number of trades were cancelled. Broker-dealers that normally route orders to Knight have temporarily ceased to send it business until the air is cleared.

Knight opened for trading this morning, saying that it still complied with regulatory capital requirements. Nevertheless, its capital position is reportedly not pretty, and news stories indicate that it's seeking a capital infusion, plus an emergency loan from a major bank. Knight may not survive if it doesn't establish confidence among the broker-dealer community within a day or two.

And that's the really scary thing about the Knight debacle. It's conceivable that Knight could have been rendered immediately insolvent if its big trading glitch had lasted a bit longer, or had involved a somewhat larger number of transactions. Such an insolvency would have impacted Knight's counterparties, possibly imperiling them if their exposures to Knight were large enough. If these counterparties had become insolvent, the financial miasma could have spread and other firms knocked down like falling dominoes. All this, potentially, because of less than an hour's computerized trading gone haywire.

The risk of insolvency in such a situation could be heightened by the fact that other market participants might observe such a debacle in real time and pull their accounts before the trading day ended. This, were it to occur, would amount to a run on Knight. Now that the financial community knows that Knight (and perhaps its competitors) can become imperiled within an hour's time, they might be all the quicker to grab for their money first, and ask questions later. The quaint display of depositor anxiety so sentimentally portrayed in It's A Wonderful Life would be a mere box car compared to the Maserati of broker-dealer flight in our world of computerized trading.

Sadly, regulators would probably have little or no idea of what would be going on. The SEC recently adopted rules for a consolidated audit trail with a requirement to report trades to the agency. But the new rules call for next day reporting to the SEC. The agency wouldn't be able to track in real time what the cannoli was going on, and hence would be behind the curve as market participants cut and ran.

Of course, the Federal Reserve would jump in with bailout checks for one and all of the imperiled firms if a meltdown of the financial system loomed. But the availability of desperation-driven, last ditch bailouts offers little comfort. More than ever, market participants and regulators need to get a handle on computerized trading. The ability of computers to execute vast numbers of ridiculous trades without any constraint is really, truly, seriously dangerous. By all indications, the financial markets are now operating on a sudden death basis. That cannot end well.