By Renee Kramer
On October 16, 2013, the Securities and Exchange Commission (SEC) announced that Knight Capital Americas LLC (“Knight Capital”) has agreed to pay $12 million to settle charges that it violated the agency’s market access rule in connection with the firm’s Aug. 1, 2012 trading incident that disrupted markets. (Knight Capital was formerly a subsidiary of Knight Capital Group and, as of July 2013, is now a subsidiary of KCG Holdings, Inc. Knight Capital Group’s biggest business was in market-making of U.S. equities for retail brokerages and it was known on Wall Street as the biggest trading firm.)
The SEC’s market access rule, or Exchange Act Rule 15c3-5, applies to broker-dealers with market access to an exchange or alternative trading system (“ATS”), as well as to broker-dealers that provide customers or other persons with that same market access. The SEC adopted the rule in 2010 because of the potential that firms were not properly managing placement of orders and thereby exposing customers to financial, regulatory and other risks associated with those order placements. The rule specifically prohibits broker-dealers from providing customers with “unfiltered” or “naked” access to an exchange or ATS. It requires firms to put in place risk management controls and supervisory procedures to help prevent erroneous orders, ensure compliance with regulatory requirements, and enforce pre-set credit or capital thresholds.
On the morning of Aug. 1, 2012, Knight Capital sent out a wave of more than 4 million accidental stock orders that resounded through the market and led to a $460 million loss for the firm. Knight Capital maintains an automated routing system for its equity orders, known as SMARS. While processing 212 small retail orders placed by Knight Capital’s customers, SMARS routed millions of orders into the market over a 45-minute period and acquired over 4 million executions in 154 stocks for more than 397 million shares. By the time that Knight Capital ceased the orders, Knight had assumed a net long position in 80 stocks of approximately $3.5 billion and a net short position in 74 stocks of approximately $3.15 billion. After the incident, Knight Capital nearly went bankrupt as its stock price fell about 75% in two days and set off an investigation by the SEC.
The SEC explained that Knight Capital made two critical technology missteps that led to the trading incident on Aug. 1, 2012. Knight Capital moved a section of computer code in 2005 to an earlier point in the code sequence in an automated equity router, rendering a function of the router defective. Knight left it in the router, even though it had no use. In late July 2012 when preparing for participation in the NYSE’s new Retail Liquidity Program, Knight Capital incorrectly used new code in the same router. As a result, certain orders eligible for the NYSE’s program triggered the defective function in Knight Capital’s router, which was then unable to recognize when orders had been filled. Apparently, on the morning of Aug. 1, 2012, 97 automated emails were sent to a group of Knight Capital personnel that identified an error before the markets opened but Knight Capital did act upon them.
The SEC’s investigation found that the firm did not adequately safeguard market access in the disruptive trading incident, nor did the firm sufficiently review its controls. The SEC’s order requires Knight Capital to pay a $12 million penalty and retain an independent consultant to conduct a comprehensive review of the firm’s controls and procedures to ensure compliance with the market access rule. Without admitting or denying the findings, Knight Capital consented to the SEC’s order, which censures the firm and requires it to cease and desist from committing or causing these violations.
For a copy of the SEC’s order please see: SEC Order – Knight Capital