Bloomberg News

Knight Says Loss May Spur Curbs on ‘Knuckleheads’ Errors

September 11, 2012

Knight Says Loss May Spur Rules to Prevent ‘Knucklehead’ E

Knight Chief Executive Officer Thomas Joyce, who is also chairman of Knight, said he was “deeply embarrassed” his company’s Aug. 1 fiasco added to mishaps such as Nasdaq Stock Market’s botched initial public offering of Facebook Inc. that helped fray retail investors’ confidence in markets. Photographer: Andrew Harrer/Bloomberg

A trading loss that almost sent Knight Capital Group Inc. (KCG:US) into bankruptcy may spur regulatory changes to protect against future errors by “knuckleheads,” Knight Chief Executive Officer Thomas Joyce said.

Knight was rescued by an investor group after a computer malfunction caused a $440 million trading loss on Aug. 1. The mistake resulted from Knight software that wasn’t properly installed as the market maker prepared for a new NYSE Euronext (NYX:US) program meant to attract retail investors, Joyce said.

Regulators and market participants may examine whether trading curbs that focus on sudden price moves for individual stocks and exchange-traded funds should also consider volume, Joyce said. A review of the so-called clearly erroneous execution policy, which spells out when trades can be canceled by exchanges, is also likely as the securities industry assesses the Knight error, he said.

“There’s no reason to put a firm at risk because some knucklehead or series of knuckleheads at the firm made a big mistake,” Joyce said today at a Barclays Plc conference in New York. “If there’s an error, you should be able to fix an error.”

International Business Machines Corp. (IBM:US) was hired to review Knight’s development process and is expected to deliver a report to Knight’s board in the next three months, Joyce said today.

Clients Return

While the company’s share of volume in equities and ETFs plunged on the day of the Aug. 1 error, “Knight has largely regained market share, and we did it within two weeks,” Joyce said. Resolving trading problems and getting new financing is “all for nothing if the clients don’t return,” he said.

The Jersey City, New Jersey-based company received a $400 million cash infusion through the sale of convertible equity a week after the trading loss. Shares outstanding nearly doubled to 181.7 million as Jefferies Group Inc. (JEF:US), one of the brokerages which arranged the bailout, converted almost all of its preferred stock this month.

Knight had $510 million in cash (KCG:US) as of Aug. 31, up from $365 million on June 30, according to today’s presentation. The company chose equity over debt because it would result in “a much healthier balance sheet,” Joyce said.

‘Deeply Embarrassed’

Joyce, who is also chairman of Knight, said he was “deeply embarrassed” his company’s Aug. 1 fiasco added to mishaps such as Nasdaq Stock Market’s botched initial public offering of Facebook Inc. that helped fray retail investors’ confidence in markets. A software bug that went undetected led Knight to generate orders “unrestricted by volume caps,” he said.

More than 90 percent of clients using Knight’s market- making and broker-dealer services are again trading with the firm, Chris Allen and Joe Recendez, analysts at Evercore Partners Inc. (EVR:US), wrote in a Sept. 5 note. More than 70 percent of institutions have also returned, with more expected after “internal credit reviews” are conducted this month, they said.

Knight shares rose (KCG:US) 1.1 percent to $2.70 today in New York trading. The stock is down 74 percent since the day before the software error.

Trading curbs implemented after the May 6, 2010, flash crash in which the Dow Jones Industrial Average (INDU) plunged 9.2 percent before recovering, temporarily halt stocks if they fall 10 percent within five minutes. Joyce said regulators may consider extending the so-called single-stock circuit breakers to securities experiencing unusual trading volume.

“I do think we will have a regulatory review of volume circuit breakers and a regulatory review of how one handles an error,” Joyce said. “Make no mistake -- this was an error.”

NYSE ‘Hamstrung’

While the New York Stock Exchange was willing to consider canceling more trades for stocks listed on its market during Knight’s problems on Aug. 1, the Securities and Exchange Commission nixed the idea due to transaction-voiding rules enacted after the May 2010 plunge, Joyce said. The regulations “hamstrung” NYSE, he said.

Kill switches, or mechanisms that enable an exchange or broker to shut off all trading from a firm, are also likely prospects as regulators and industry participants review problems such as the Knight technology glitch, Joyce said. He cautioned that stopping all trades from a firm when a problem occurs in one business segment could hurt clients operating through another unit.

‘Biggest Issue’

Long-held industry concerns about “regulatory risk” and the damage that government agencies can do to the businesses of banks and brokers may have been supplanted by fears of operational risk like the incident that nearly crippled Knight, Joyce said.

“I was mistaken,” Joyce said. “Regulatory risk was not our biggest issue.”

Knight will announce a new chief risk officer soon, according to Joyce. The person will be responsible for market, credit and operational risk, and the company will add staff to support the changes being made, he said. Financial firms need to focus on operational-risk issues at the board, management and governance levels, he said.

At the same time, trading mistakes can’t be eradicated completely by efforts to avoid errors, Joyce said.

“I don’t know if there’s any great way you can unearth somebody’s mistake ahead of time,” Joyce said. “People do stupid things and it’s sad and I wish we could regulate against that, but I don’t see that completely happening.”

Knight will soon shift to thinking strategically about the company’s businesses after fixing problems identified in the wake of the August loss, Joyce said. He added that the company aims to be smarter and stronger after what he described as the “most dramatic” event in Knight’s history.

“The present moment is a good one to reassess not just technology but all of Knight’s operations and offerings,” Joyce said. “Everybody will have to go through a bit of a burden of proof to make sure that the businesses they have are utilizing capital properly and that priority No. 1 remains taking care of our clients properly.”

To contact the reporters on this story: Nina Mehta in New York at nmehta24@bloomberg.net; Whitney Kisling in New York at wkisling@bloomberg.net

To contact the editor responsible for this story: Lynn Thomasson at lthomasson@bloomberg.net


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