Knight Capital agrees to $12 million settlement for 2012 errors

October 17, 2013 08:34 AM

Securities regulators fined Knight Capital Americas LLC $12 million for the trading malfunction that roiled the U.S. stock market in August 2012, saying the firm ignored dozens of error messages before its computers bombarded exchanges with millions of unintended orders.

Knight, which in July joined with Getco LLC to form KCG Holdings Inc. after losing more than $460 million because of the error, agreed to settle charges stemming from mistakes made on Aug. 1, 2012, according to a statement today from the U.S. Securities and Exchange Commission. The regulator said Knight violated the SEC’s market access rule, instituted in 2010 to prevent these kinds of trading missteps.

The administrative order outlining the settlement painted Knight not as a victim of computers gone haywire, but as a firm that failed to test its systems adequately or prepare for potential breakdowns. Knight’s mistakes led to it making more than 4 million trades in response to only 212 orders from investors, for a total of 397 million shares changing hands. That prompted the losses that brought Knight to its knees.

“Knight’s system of risk management controls and supervisory procedures was not reasonably designed to manage the risk of its market access,” the SEC said in the order released today. “Knight’s internal reviews were inadequate, its annual CEO certification for 2012 was defective, and its written description of its risk management controls was insufficient.”

Messages Ignored

The SEC found that Jersey City, New Jersey-based Knight didn’t have adequate safeguards, didn’t act on error messages, and didn’t have guidelines for responding to such issues. The mistakes were the result of human, not computer, errors, said Daniel Hawke, chief of the SEC Division of Enforcement’s Market Abuse Unit.

The SEC sees a distinction between “calling something a glitch that is inevitable in many technology systems and applications versus something that is about failure to adopt controls that are reasonably designed to manage the risks associated, in this case, with market access,” Hawke said during a conference call today with reporters.

Knight’s system generated 97 e-mails alerting staff to problems before the markets opened on Aug. 1, 2012, the SEC said. These notifications were not acted upon by employees of the broker-dealer, according to the regulator.

“Although Knight Capital did not design these messages to be system alerts, they provided an opportunity to identify and fix the problem before the markets opened,” the SEC said.

Knight’s losses required it to seek emergency financing and ultimately merge with Getco.

‘Rapid Pace’

“Given the rapid pace of trading in today’s markets and the potential massive impact of control breakdowns, broker- dealers must be held to the high standards of compliance necessary for the safe and orderly operation of the markets,” Andrew Ceresney, co-director of the SEC’s Division of Enforcement, said in the statement announcing the settlement.

“We are pleased to put the events that occurred at Knight Capital on Aug. 1, 2012, behind us,” Sophie Sohn, a KCG spokeswoman, said in an e-mail. “KCG is a new company formed from the transformational merger between Knight and Getco earlier this year. KCG is committed to employing best-in-class risk management processes.”

In a client letter seen by Bloomberg News, KCG outlined the changes it has made to address some of the shortcomings highlighted by the SEC. The firm now has a 24-hour risk management center with staff from all its units, automated alerts, stronger testing and certification to ensure it complies with market access rules, and a chief risk officer, KCG Chief Executive Officer Daniel Coleman told clients in the message.

New Controls

“We have developed and implemented a layered system of automated controls to monitor trading at numerous junctures within the system and automatically shut down trading activity at predetermined thresholds,” he wrote.

While today’s action is the SEC’s first under the market access rule, it will be an important area of enforcement in the future, Ceresney told reporters during today’s conference call.

“Investors should know that we will enforce the market access rule vigorously,” he said. “Companies must have controls in place to guard against mistakes and the consequences of such mistakes.”

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