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Was Knight's Disaster Caused By Lack of an Off Switch?

If true, this marks a gross oversight, as algorithms fire off hundreds of shares per second.

When Knight Capital Group's computerized stock trading went postal last Wednesday, one mystery was why it took so long to shut the machine off. It was shocking to learn from the New York Times that there possibly was no "off" switch.

On Friday, when Knight was struggling to arrange emergency funding to last through the weekend, market insiders and even other electronic trading firms were left pondering the same question.

If this is true, this is a serious oversight, since algorithms are executing hundreds of trades per second and, in Knight's case, the algo drove up trading volume in dozens of U.S. companies, ultimately causing the firm to unwind the trades and lose $440 million.

From the New York Times:

As Knight struggled to survive on Friday, employees at the company, market overseers and other electronic trading firms were asking the same basic question: Where was the off switch?

Several market insiders said that they were bewildered, because in a market where trading losses can pile up in seconds, executives typically have a simple command that can immediately halt trading.

"Even just a minute or two would have been surprising to me. On these time scales, that is an eternity," said David Lauer, a trader at a high-speed firm until a year ago. "To have something going on for 30 minutes is shocking."

Usually, in software development, it is standard practice to include a kill-switch. "They forgot to build in a crowbar circuit," my husband, an electrical engineer, explained to me. "It looks like they took short cuts on software."

[In the absence of regulation to protect the markets, participants seem to have punished Knight Capital for its careless software error.]

What's disconcerting is that the New York Stock Exchange noticed the excessive volume and contacted the company within minutes of the 9:30 a.m. opening bell, the New York Times noted. Knight's delayed response was said to be "mystifying" to other traders because the firm had introduced new trading software that day, which usually causes executives and programmers to be "on high alert."

Humans had to intervene, but where were those people? Were they on vacation? Taking a coffee break? Was there confusion over who had authority? Was there a disconnect between those in electronic brokerage and technology? It's also been suggested that with lower trading volumes firms may not be keen to hire more personnel to monitor their machines. But if they're not adequately staffed to monitor rapid fire automated trading, then perhaps they should invest in more software to monitor the algos. Ultimately, when alarms are set off, there needs to be a person in charge.

Regulators at the SEC are reportedly looking into why there was such a lag between the time the problem was discovered and the point at which the software program was turned off. Since Knight is one of the largest market makers in U.S. stocks, the SEC is said to be examining if the firm violated any legal obligations.

Knight's errant software program has turned up the spotlight once again on the need for risk controls in high speed trading, particularly in a complex market structure where lots of disparate systems interact. Reviewing the basics of software development and how to put the brakes on runaway code isn't just a good idea. It's also plain common sense.

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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