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Rogue Trader: The Knight Capital IT Crash
When things go wrong in automated high frequency trading, they can go disastrously wrong. This is perhaps unsurprising when you consider that about 165,000 separate trades can be completed by a high frequency trading platform, which buys and sells large volumes of stock in short periods of time, in the time it takes for Usain Bolt to react to a starting pistol.
- actually a test program designed to simulate trade requests and evaluate if they went through properly; or
- not exhaustively tested and failed to pick up the interaction with a high-frequency trading algorithm.
What are the effects?
First and foremost there are effects on the company affected by the trading glitch on their reputation in the market place and often their financial viability which causes clients to drain away. It has been a very embarrassing episode in Knight Capital’s history as it had previously been a well-respected market maker until the incident. In the immediate aftermath Vanguard Group and Fidelity Investments did not route trades to Knight Capital due to a lack of confidence in Knight Capital’s systems.
There is also a wider macro effect as a result of lower confidence in the strength of the market infrastructure to deal with such disruptions which lead to large losses. A recent study showed that only 2% of 260 respondents rated their confidence in the US equity market structure as “very high” compared with 12% after the “flash crash” in 2010. The likelihood is that pending improved regulation in the area of automated high frequency trading in the UK and US is likely to bolster the low confidence in the market.
It is understood that the Financial Services Authority (FSA) in the UK is considering introducing stricter rules in relation to high frequency trading following a review of such practices earlier this year. So it is highly likely that further regulation in this area will also be introduced in the UK as well as the US following the Knight Capital crash.
Prevention is far better than cure
As lawyers in the financial services field we scratch our heads and wonder what part we can play in protecting our client or our company from such a risk. There will certainly be a role in interpreting the forthcoming regulations regarding high frequency trading to be introduced by the FSA. In addition, to the extent that there are any IT suppliers or external consultants involved in providing program code for trading purposes lawyers acting for the recipient will need to ensure that as much risk as is reasonably possible is placed on the IT supplier to deliver suitable and tested software code and implement such code in a way that minimises the risk of a trading collapse.
It is customary in important services agreements to have a disaster recovery plan if, for example, unusual incidents beyond the reasonable control of the supplier (e.g. fire or flood) occur without warning. The impact on the provision of the services is reduced by the implementation of a well thought out plan as to how to deal with such circumstances to ensure the continuation of services. If trading companies have not done so already they should consider having a financial disaster recovery plan, such that certain steps are identified in advance which would be taken in the event of a catastrophic financial incident (such as a defect in a high frequency trading platform) occurring.
There are also practical and operational issues which the legal team can raise in an effort to de-risk the business of a trading company, such as:
- Testing code. Clearly had the defective software code been tested prior to introduction onto Knight Capital’s live IT environment then it is likely the disastrous ramifications would have been picked up nullifying the problem. In addition, any such implementation of new software code could be subject to a soft launch in the live environment prior to market opening (e.g. at a weekend or overnight) and monitored so that any unusual activity can be identified at the earliest opportunity.
- Human oversight. A criticism of Knight Capital is that it took so long for them to notice the problem when other market participants were aware of a potential issue minutes after the market opened. Stating the obvious, trading companies should ensure that there is a human being which is responsible for monitoring all trading systems of a company at times when the markets are active to identify irregular trading emanating from its automated trading systems. Although such algorithms have their own in built safety systems human oversight can double-check when those are not performing or there are unexpected situations. Clearly the nominated person should have written operating parameters for each high-frequency trading system and where a system performs outside such parameters have the authority and instant ability to flip the “off” switch to give the company time to react and rectify the issue.
- Circuit breakers. Following the “flash crash” the Securities and Exchange Commission (SEC) introduced circuit breakers based on the increase or decrease in the price of individual stocks. Perhaps there also needs to be a wide spread introduction of circuit breakers in relation to large trading volumes on particular stocks as the price based circuit breakers didn’t avert the large scale losses of Knight Capital. The SEC is looking at this issue and will “accelerate ongoing efforts to propose a rule to require exchanges and other market centers to have specific programs in place to ensure the capacity and integrity of their systems”.
What can be done if the worst happens?
It is clear that regulators (particularly in the US) will be reluctant to help. The SEC refused to have the majority of the $7 billion worth of trades made by Knight Capital cancelled as those trades didn’t increase the share price of the majority of the purchased stocks by more than 30%, the cancellation threshold, which followed the rules established after the flash crash in May 2010. This reiterated that regulators are not there to keep financial institutions afloat but rather guard against systemic risk in financial markets.
Even though legal terms may state that a trading company is not responsible for trading losses of its clients, it is unlikely that a company would choose to place the losses on their clients as it would destroy its client base and it would be unlikely to receive any support in the market to recapitalise itself.