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Ivy Schmerken
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SEC Intensifies the Knight Probe and Shifts Focus to Risk Controls

The regulatory investigation of Knight Capital's trading glitch on Aug.1 could turn into a lesson for Wall Street on how the regulator will enforce the new market access rule.

Knight Capital Group would no doubt like to put to rest the endless media coverage and attention paid to its Aug. 1 technology glitch that racked up $450 million in losses and nearly toppled the firm.

But according to today's Wall Street Journal, the Securities and Exchange Commission is broadening its investigation to look deeper into the firm's risk control procedures as well as its compliance with the market access rule implemented last year.

While the regulatory inquiry originally focused on what caused the trading errors, it has expanded the inquiry to look at the risk management controls that are supposed to prevent such errors from wreaking havoc in the markets.

After a series of technology errors this year that ruined the BATS IPO and marred the Facebook IPO, culminating in the Knight episode, the SEC's expanded probe is looked upon as a test to hold brokers accountable for technology snafus which have shaken investor confidence in the stock market, suggests the WSJ story.

But the SEC's decision to "intensify" the probe is viewed as a setback for Knight since the broker wanted to put the painful episode behind the firm and move forward. In fact, Knight's board voted to approve a settlement with the SEC, sources told the WSJ.

Knight reportedly conveyed the board's settlement overtures to the SEC before it was to report third quarter earnings in mid-October, but WSJ said the regulator didn't respond.

The SEC's investigation has been examining whether Knight sufficiently tested its computer systems after installing code on its servers that was to interface with a new retail system at the New York Stock Exchange. Knight software sent off a litany of unintended trades in 140 or so symbols to the NYSE.

However, it appears the investigation has shifted to encompass the firms' ability to control its systems and prevent erroneous orders from entering the market and causing a ripple effect. It also may signal that the regulator is scrutinizing the way that broker-dealers are adhering to the market access rule.

What is the Market Access Rule?

The rule, adopted on Nov. 3, 2010, requires any broker dealer with market access (to an exchange and alternative trading venues or ATSs) to establish and enforce risk management controls and supervisory procedures. Originally, the rule was targeted at broker-dealers providing sponsored access to customers, including proprietary trading firms and hedge funds.

However, the market access rule is not limited to sponsored access, noted Nasdaq's FTEN unit in a trader alert.. It applies to a broker dealer's own proprietary accounts as well as a broker trading as an agent for a customer through a traditional agency brokerage. It also applies to brokers enabling customers to trade via direct- market access.

In the case of Knight Capital, the errors occurred in the firm's market making unit.

The scrutiny into Knight's compliance with the market-access rule could be a test case for how the SEC will police the rest of the industry.

From the WSJ Story:

Securities industry executives and lawyers are watching the inquiry into Knight closely, seeing it as indication of how the regulator will enforce the market-access rule--and how costly the errors might be for the firms that violate it. Stakes are high for the SEC and brokers alike, as they face pressure to show they are doing enough to prevent isolated computer errors from ballooning into market-jarring debacles.

"The SEC needs to show it has an industrywide plan to improve market confidence, and show that the number of these mishaps is going to decrease significantly," says David Weild IV, a former Nasdaq executive who's now an adviser at Grant Thornton LLP.

Updating policies and procedures for testing software and monitoring trades in real time in required under the market access rule, according to the WSJ story. Another aspect of the rule are "sign-up controls," in which chief executives of broker dealers are required to "certify" annually that their controls are "reasonably designed to manage the financial, regulatory, and other risks" associated with trading, reports the WSJ.

This could put Knight's Chairman and CEO Thomas Joyce on the hot seat since he is also CEO of Knight Capital Americas LLC, a unit that includes the market-making group where the error occurred on Aug. 1, reports the WSJ. A different executive who left the firm had signed off on Knight's compliance with the rule before July, suggesting that Joyce is off the hook.

In terms of the software error, sources familiar with the matter told the WSJ that a seasoned technician "successfully loaded code onto seven servers" except for one other server, and that "dormant code" was accidentally released onto the NYSE.

As for why the firm was not able to quickly shut down the systems after they went awry on the NYSE, this is still unknown. But again, the SEC could look at the market access rule's requirement that "appropriate surveillance personnel" be on hand "to receive post-execution reports," so someone could stop the system after it goes berserk. All in all, a more intensive inquiry into Knight's risk controls could shed light on how the SEC will enforce the market access rule.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio
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