Insert Catchy Knight Capital Pun Here

OK, now that you've thought of a cute pun that hasn't already been used by the plethora of oh-so-creative business news agencies over the last few weeks, we can talk about the important stuff. 

Knight Capital - it's a name that most individual investors know little or nothing about. But, in reality, most mom and pop investors (like yours truly at InvestindDecoded) have probably used its services at some point in our investing lives. That is why what happened to the company on the now infamous day on August 1st is very relevant. In my opinion, the events at Knight highlight a growing issue and a fundamental challenge faced by most industries in time of rapid technological change - technology evolving faster than regulations and, in some cases, common sense can ever hope to match. 

What Does Knight Do?

Knight Capital is essentially an online market exchange for stocks, options, bonds, etc. It's not too dissimilar to the NYSE or NASDAQ in that stocks are traded on its platform as the company processes orders and matches buyers and sellers. Further, and this is important, it also acts as a market maker. This means that, in the absence of sufficient buyers when there are many sellers and vice-a-versa, it is willing to step in and provide liquidity (i.e. take the other side of the trade for a short period of time - usually a few seconds) for the stocks that come through it's platform. In other words, not only does it act like a market place matching buyers and sellers, it may also become a buyer or seller as needed. 

Knight's process is done purely electronically through algorithms, which, in theory, are being monitored by humans. The point is, electronic trading can be faster and more efficient, thereby reducing transaction costs and reducing market disruptions. 

What Happened?

On the morning of August 1st, the NYSE reported unusual trading in several stocks. Stocks were trading very erratically and had volume 10's of times their normal daily amount, in just 45 minutes. Eventually Knight came out and said that the issue was related to a technical glitch in their system.

Now, there hasn't been any official cause determined for the glitch (I'm sure the Knight programmers are hard at work pinpointing the reason). But there have been very credible theories. 

Prior to 8/1, Knight released a software update to it's market making software. As many of you IT'ers now, all software goes through a rigorous testing process prior to being released, and this was no exception. To test the release, however, Knight had created a tester to simulate what a market would look like in the real world. In other words, the tester's job was to send through fake orders through the market making software, so the market making software could do its job. The tester didn't care what it was buying or selling, or for how much. Therefore, it was losing money on essentially every trade (by buying at the ask and selling at the bid). No worries though, it's just the testing world, not the real one. 

The worries start when you release the updated software into the real world, and you don't realize that the tester is still in there. That's exactly what happened at Knight. The new release was turned on on 8/1, and the tester started doing it's job, but this time in the real world. It kept on spitting out order after order, and the market maker kept filling it, but this time with real stocks. Knight then became a market maker for the stocks and begin buying and selling them, but at exactly the wrong price so as to lose money on every trade, and there were thousands of trades done.

In the end, Knight was in for a huge load of pain. For a company that made $115 million in profit last year, it had lost $450 million in the 45 minute span. The stock went from $12 to $2, and the company's very existence was in doubt until it was able to secure financing by essentially selling a majority of itself to a group of investors.

The Risks of Technology

Knight's issues are just the latest in a series of 'technical glitches' in the marketplace. I don't think these 'glitches' are necessarily becoming more frequent, but their impacts have grown. Other examples include the Flash Crash of 2010 where the Dow Jones  experienced an almost 1000 point swing in a matter of minutes. Facebook's IPO is another example along with the BATS IPO. The key, I think, is that technology in market structure is growing much faster than regulation can keep up. I don't think high frequency algorithmic trading is necessarily a bad thing for the market (although I do doubt some of the benefits touted by some of its proponents). But if it's implemented without the proper safeguards in place, you will continue to see the Knight Capital issues occur. In the case of Knight, there was no circuit breaker switch built into the system to put an emergency stop in place. The SEC, which in some instances could cancel trades that were erroneous, and did so for a small subset at Knight, did not intervene because Knight was the only one bearing the pain of the issue. Nonetheless, it's an issue that I feel will continue to get bigger without a truly robust controls process in place to minimize the general market from technology's gremlins.

Investor Impact

As individual investors, we may not directly see the impact of this in our daily lives, and nor should we. When you place a trade in Ameritrade, E-Trade, etc., it gets filled at a reasonable price commiserate to the risk you're taking with that trade. However, issues like Knight have a larger psychological impact on confidence in the marketplace. When these types of issues continue popping up, if the pain is felt by the greater public (I think anyone who bought FB at $45 on its IPO day and couldn't close the position later felt that pain), there's definitely a down the line impact for all investors. 

What are your thoughts? 

Questions/Comments/Feedback? Please don't hesitate to let me know. Suggestions on posts you'd like to see? Let me know!

The Standard Disclaimer:
Everything I've written above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary due diligence prior to acting on any recommendations, including consulting a financial adviser.