(August 3, 2012) — With Knight Capital’s recent trading blowup resulting in a $440 million pre-tax loss, investors are not only fearful that the company will collapse forcing trading clients and creditors to accept losses. They are also fearful with the knowledge that this type of trading fiasco is surely not the last of its kind.
According to the firm, the issue stemmed from installation of trading software, which resulted in its algorithmic trading systems sending out “numerous erroneous orders in NYSE-listed securities…Clients were not negatively affected by the erroneous orders, and the software issue was limited to the routing of certain listed stocks to NYSE,” a statement released by the firm concluded.
But with algorithmic trading not expected to go away anytime soon, how can an investor be equipped to handle abnormal market events and crises?
From the perspective of an asset owner, such as a pension fund, there must be greater emphasis placed on on asset managers to do proper due diligence, James Koutoulas, CEO of Typhon Capital Management, told aiCIO. “If a pension were in Vanguard or Fidelity, those mutual funds were using Knight to execute orders — so a pension would have to defer to an asset management firm investing in Fidelity, questioning them on their counterparties.”
According to Koutoulas, events such as the losses at Knight, which have forced the firm to seek new funding as its shared plummeted, will become more and more frequent as market trading becomes increasingly global and fast-pased. “The New York Stock Exchange floors are ghost towns — humans have been replaced by computers. But I think humans are generally better equipped,” Koutoulas said. In other words, Knight’s massive losses have highlighted the reality that simplicity and human reasoning far exceed the limitations of computers and algorithmic trading. “Complexity is not a good thing — I don’t know what value is added to society by allowing high frequency firms to execute in nano seconds,” Koutoulas added, concluding that the lack of a human touch when it comes to algorithmic trading is at the detriment of the financial industry.
Eric Hunsader, CEO of market data service Nanex, told aiCIO that algorithmic trading reflects a disconnect from reality: “When there’s a problem with data, all the machines quit. With any unexpected news, markets will collapse.” He noted that the problems with algorithmic trading come from an over-reliance on speed.
“Although the company’s capital base has been severely impacted, the company’s broker/dealer subsidiaries are in full compliance with their net capital requirements. Knight will continue its trading and market making activities at the commencement of trading today,” a statement released by the battered trading firm said. “The company is actively pursuing its strategic and financing alternatives to strengthen its capital base.”
For now, industry sources caution institutional investors to mitigate the damaging impacts of future trading failures through operational diversification — ensuring redundancy with everything from custodians to clearing brokers. “In this world, in 45 minutes you can have a loss with an entire balance sheet, so you can’t put all your eggs in one basket,” Koutoulas said.