* 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 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
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,
"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
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
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
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
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
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
"This is a wake-up call to think about other things that
could go wrong and is your program ready for that?" he said.