US SEC examining risk controls at Knight Capital
* SEC's market access rule requires risk controls
* Schapiro says SEC looking to see if Knight complied
* Rule was adopted following May 6, 2010 flash crash
* Industry sources say Knight rushed its software
By Sarah N. Lynch
WASHINGTON, Aug 3 (Reuters) - The top U.S. securities regulator said government lawyers are trying to determine if Wednesday's big trading blunder at Knight Capital Group violated a new rule designed to protect the markets from rogue algorithmic computer trading programs.
The Securities and Exchange Commission's market access rule, which took effect last year, requires brokers to put in place risk control systems to prevent the execution of erroneous trades or orders that exceed pre-set credit or capital thresholds.
The rule gets at the heart of what went wrong on Wednesday at Knight, after a software error led the brokerage to flood the market with erroneous orders over the course of 45 minutes.
The new rule was one of the SEC's response to earlier problems with super-fast automated trading, including the so-called flash crash in May 2010 when the Dow Jones Industrials plunged about 700 points in several minutes.
This latest technology snafu will likely fuel renewed interest by the SEC to take a closer look into automated, high-speed trading.
"Existing rules make it clear that when broker-dealers with access to our markets use computers to trade, trade fast, or trade frequently, they must check those systems to ensure they are operating properly," SEC Chairman Mary Schapiro said Friday. "And, naturally, we will consider whether such compliance measures were followed in this case."
The computer mishap left Knight with a $440 million loss and now the firm is struggling to find new sources of capital to survive.
The SEC is examining how the algorithmic error got unleashed on the markets and whether the software used by Knight was properly tested before it was put into use on Wednesday. But regulatory sources say it's too soon to say whether a full-fledged enforcement investigation will be commenced.
Industry sources said that Knight may have rushed out its program without testing it appropriately to get ahead of its competitors.
Spokespeople for Knight Capital Group did not return calls or emails seeking comment.
Michael Bachner, an attorney who earlier this year represented a defendant in the SEC's first-ever market access case, said he suspects Knight probably will face regulatory troubles down the road.
"With the magnitude of the problem that occurred, it seems to me there is a likelihood that there was some problem in their risk controls," Bachner said.
Knight's trading woes this week mark the latest blow to investor confidence in a recent string of technology errors by major market players. In May, Nasdaq OMX came under fire and is now the subject of an SEC investigation into its botched initial public offering of Facebook.
BATS Global Markets also in March suffered a technical snafu, forcing it to kill its own initial public offering on its own exchange.
MARKET ACCESS RULE
The market access rule was one of several adopted by the SEC following the May 6 "flash crash," though its implementation was delayed until late 2011 as brokers sought more time to get their systems ready.
The rule came as a response to the growing concerns about "fat finger" and algorithmic computer problems which have the ability to ricochet through the market in a matter of milliseconds.
The centerpiece of the rule was focused on banning so-called "naked access," where brokers give high-speed traders a direct pipeline into exchanges without any pre-trade supervision.
It requires brokerages to devise controls to help supervise the firms it may sponsor, such as hedge funds. But those oversight responsibilities also extend to reviewing their own orders as well.
In Knight's case, it had recently developed the software to use in the New York Stock Exchange's newly implemented Retail Liquidity Program, or RLP. The program was introduced as a way to spur more liquidity by offering retail investors better pricing on trades.
The software was coded incorrectly and led to the trading malfunction that sent some stocks spiraling and others soaring. The combination of erroneous trades led to Knight's $440 million loss, something that severely depleted its capital.
Making matters worse, the company apparently did not have its old system running at the same time in case of a malfunction - what software geeks call a "redundancy" - which is standard protocol for introducing new software into real-time trading situations, several industry sources said.
That forced Knight to shut down its system entirely and stop processing trades for clients until the issue could be resolved.
Michael Goldstein, a professor of finance at Babson College, said the problems at Knight may prompt the SEC to conduct a more wide-spread review of the risk management systems for all brokerages.
"This is a wake-up call to think about other things that could go wrong and is your program ready for that?" he said.
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