Friday, August 3, 2012

Wall Street: Knight of the Rogue Algorithm

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Lost in the news because of the Romney Shambles tour and the London Olympics, a big thing happened on Wall Street this week - another "Flash Crash" caused by the technology that now runs the markets.

There have been several of these over the past few years, with real financial consequences including multiple lawsuits, including the Nasdaq crash the day the Facebook IPO was offered.

When Algorithms Go Bad . . .

From the New York Times
Traders on Wednesday said that a rogue algorithm repeatedly bought and sold millions of shares of companies like RadioShack, Best Buy, Bank of America and American Airlines, sending trading volume surging. While the trading firm involved blamed a “technology issue,” the company and regulators were still trying to understand what went wrong.

The debacle comes after the botched Facebook initial public offering on the Nasdaq exchange in May and the aborted effort in March by another exchange, BATS Global Markets, to bring its own stock public. The episodes, along with the flash crash of 2010 when the market lost trillions of dollars of value in minutes, have stoked suspicions that stocks are safe only for specialists, and sometimes not even for them.

“The machines have taken over, right?” said Patrick Healy, the chief executive of the Issuer Advisory Group, a capital markets consulting firm. “When events like this happen they just reaffirm that these aren’t investors, these are traders.”

The errant trades began hitting exchanges almost as soon as the opening bell rang and came from a single New Jersey broker that specializes in computer-driven trading, the Knight Capital Group. Shares of more than 100 companies, including big names like Alcoa, Citigroup and Ford suddenly spiked up or down. The New York Stock Exchange had most of the mistaken orders, but all of the nation’s exchanges executed trades for Knight and all agreed to cancel the trading in six stocks that had especially extreme movements.

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Via ZDNet
Knight Capital Group this week botched a software upgrade that triggered erroneous New York Stock Exchange orders at market open Aug. 1. These orders resulted in a $440 million pre-tax loss. The problem? As of June 30, Knight had $364.8 million in cash and equivalents.
The company has until Monday night to find enough cash---via credit lines, cash infusions or an investor---to settle the trades.
In a statement, Knight Capital, which also lost $35.4 million related to the Facebook IPO in its second quarter, outlined the software glitch.

. . . Overall, about 150 stocks were affected as a wayward algorithm flooded them with buy and sell orders. Knight's software update was tied to a new NYSE trading platform.

. . . What's shocking about the Knight situation---as well as other algorithm and software issues with Wall Street systems---is that one screw-up can wipe out a company. Knight isn't some dinky player. Year-to-date Knight has traded $21.5 billion worth of stock a day on average as well as 3.3 billion trades a day.


Knight Capital called it a "technical problem," but it was way beyond that, and seemed to have no human oversight for many hours, which bothered many traders and market watchers.

From the LA Times:
. . . the debacle highlights concerns on Wall Street and in Washington about structural flaws in the U.S. financial system. Observers are worried that the reliance on computer-driven trading, where stocks are bo"ught and sold in the blink of an eye, could lead to a major equities meltdown.
"The ghosts in the machine have gotten out of control," said Larry Tabb, chief executive of Tabb Group, a financial research and advisory firm. "There are increasingly more problems and we haven't been able to get this right."

. . . Former Sen. Ted Kaufman, a vocal critic of high-frequency trading and how Wall Street has evolved, criticized Congress for denying the SEC adequate funding to do its job. He said post-"flash crash" regulations — even those that have yet to take effect — fail to address the larger structural problems on Wall Street.

What was once a duopoly of two major exchanges, the New York Stock Exchange and the Nasdaq, has evolved into more than a dozen separate trading platforms. There are also numerous "dark pools" where hedge funds and other large investors trade out of public view — what Kaufman likened to the Wild West.

"This is like a volcano that keeps sending out signals," said Kaufman, a Democrat from Delaware who is now teaching at Duke University's law school. Wall Street keeps sending out warnings like Knight's loss, he said, "and we're not doing anything about it."

Story from Forbes: Knight Unhorsed
Of course, who can forget May 18, 2012, when NASDAQ’s much heralded launch of the greatly anticipated Facebook initial public offering wound up in the toilet. After taking some time to first remove the ample amount of egg on their faces, the good folks at NASDAQ seemed to concede that they weren’t quite prepared for what many viewed as the single-most important IPO launch in that electronic market’s history. The Facebook IPO crash and burn is now attributed to some software glitches – whatever that truly means. The price of Facebook continues to drop as the talk of litigation against NASDAQ seems to rise.

As the piling-on of NASDAQ grew after the disastrous opening day, who can forget the no-holds-barred criticism of NASDAQ’s Facebook IPO performance by Knight Capital’s Chair and CEO Thomas Joyce ? It was only a few weeks ago, on May 21, 2012, when Joyce appeared on CNBC “Squawk On The Street” and slammed NASDAQ:
“First of all, I want to point out that this wasn’t in anyway, shape or form an industry failure. This is not a systemic issue. All of the financial services firms that were out there handling client flow handled it perfectly. This is not the first IPO that’s ever come down the pipe. They understand the process and handled it perfectly. The failure was Nasdaq’s. It was Nasdaq’s failure . . .
[T]his was a technology problem. This was like a server going down except on a massive scale and instead of stepping back and rebooting, they kept plowing ahead. . .
. . . It must be with some devilish joy that the folks at NASDAQ watch today’s unfolding developments as Knight itself experienced severe disruption of its ability to handle and transmit orders. A situation so severe that the company’s stock is down nearly 33%. We’re told, preliminarily, that there’s a software glitch that impacted order routing. Ah yes, the ever-popular high-tech scapegoat: the software glitch!


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