Technology in High Speed Trading: The Case of Knight Capital

A couple of days ago Knight Capital Inc. lost $400 million as a result of a bug in the infrastructure they put up to interface with the New York Stock Exchange (NYSE). The May flash crash is still fresh in investors’ minds; it is not unusual to be concerned about Knight Capital’s technology issues. The inability of Bats Global Markets to implement its own IPO and the botch up of the Facebook IPO by NASDAQ are recent examples of technology glitches [Reuters].

Knight Capital, that closes trades on behalf of other brokerage firms, installed a system to interface with NYSE, which sent out a series of false trades for about half an hour, before being shut down. Trading system code modification is not a static process. From time to time changes are made in the trading systems to accommodate new rules and regulations. If not tested properly during the dry runs, issues are bound to arise when the technology goes live, as it happened with Knight Capital.

The case of Knight Capital has rebought the focus on high frequency trading. The power of technology is being harnessed by these high frequency traders to make enormous profits and influencing the movement of the market, in a matter of seconds.

In the past there were professionals who matched trades between buyers and sellers, stepping in themselves when some trades were not closed. Automated trading has changed all this. Furthermore a large portion of the trading has moved away from exchanges to ‘dark pools’ where large volumes of shares can be bought and sold by investors.

One such measure the SEC has implemented is halting trades when they move beyond the prescribed limit. High frequency trades usually scoop hundreds upon thousands of shares all in a matter of milliseconds. Wall Street technologies run on powerful algorithms that spot trends, change strategies all in the blink of an eye. Since a regular investor cannot compete with these algorithms, the SEC and other regulatory agencies are now waking up to introducing controls on such trades. They are requesting for disclosures and company information from such companies.

According to the SFGate the SEC has proposed a consolidated audit trail which will collect information on trades in real time. This emphasis on controls, particularly internal, needs to be upped.

Electronically traded exchanges and players have helped break down the cliques that earlier monopolized Wall Street. They have helped in reducing the charges investors were made to pay earlier. It seems now that many of these independent players and traders are using technology to create barriers that will be difficult to scale. The architecture of the technology used by them is fairly complex and bugs in the system greatly magnify small mistakes.

It would not be incorrect to say that like shadow banking, entire new systems of trading are now in operation that does not seem to be under the purview of the SEC.

It appears that greater human intervention and control is required so that such technological breakdowns become fewer and the market stays efficient. Is this a larger issue that the trading community needs to address? Is it an issue specific to Knight Capital? Recent events seem to suggest otherwise. A more robust technological infrastructure seems to be the order of the day. One that is more transparent and better controlled. The question is if we are too far gone to rein it in.