Farr: Knightmare on Wall Street — Revenge of the Machines

Traders work on the floor of the New York Stock Exchange during morning trading on August 6, 2012 in New York City. Knight Capital has reached a deal with a group of investors for $400 million after the trading firm suffered a massive loss from a computer trading glitch last week.
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On Wednesday, August 1st, there was trading troublein the stock market.

Though it didn’t cause another “flash crash,” it had a lot of the same worrisome characteristics.

Knight Capital Group is a company that few individual investors know about, and yet it is the largest market-maker for NYSE and NASDAQ stocks. Market-makers are responsible for maintaining “fair and orderly” markets.

The floor of the New York Stock Exchange used to be elbow to elbow with market-makers and specialists who traveled the “floor” and executed trades for their clients and themselves. There aren’t many folks on the Exchange floor these days - there are computers doing a lot of trading. Through acres of computers and automation, Knight became the dominant trading house. A huge amount of Knight’s market activities are directed by computer programs that are programmed to react by placing buy or sell orders, sometimes in huge volumes, based on certain criteria supplied in real-time by whatever is happening in the markets at that moment.

According to Reuters, “Knight's computers had been loaded with new software Tuesday that was designed to accommodate a change on the NYSE, according to people familiar with the matter. When trading began at 9:30, however, the computers poured a huge number of orders into the market.

For about 10 minutes it was unclear where the orders were originating, according to people familiar with the matter. After NYSE officials identified Knight as the source, it took another 10 minutes for the company to figure out the source of the problem. By that time, the erratic orders in a number of affected stocks had triggered exchange "circuit breakers" that temporarily halt trading in volatile stocks.” This thirty minute “glitch” caused a $440 million loss.

Once again, investor confidence was wounded, and Knight was almost destroyed. The error had decimated the firm’s capital base and rendered the firm insolvent. Before the open on Monday, August 6th, a consortium of investors infused Knight with $400,000,000, thus allowing it to open for business.

Though Knight survives, it reminds all of us of the power and fallibility of computer trading programs and their sophisticated algorithms. Most regrettable was the Already shaken by the banking crisis, Great Recession, and the Flash Crash, investors were again reminded of their vulnerability. While it is one thing to understand that certain greedy, conscienceless bankers may from time to time exceed the blindest ambitions and wreak havoc, we somehow feel even more powerless when faced with powerful, faceless machines.

Earlier this week I received an email from one of our long-time, favorite clients named Richard. He asked that I write about Knight and offer some advice about how he and others should think about such occurrences as they fret about the safety of their savings. I’m always humbled by such questions because I always feel like I’m struggling right along side you. But, that said, I think that the huge computer-driven, high-velocity trading is dangerous, and last week proves why. I also think it’s here to stay. In time, Wall Street will gain the necessary controls and learn sufficient painful lessons to remedy these vulnerabilities.

People who are disappointed and anxious over lackluster returns begin to look for scapegoats and villains.

They find straw-horse arguments to justify their withdrawal from investing and move to a more comfortable but perhaps more dangerous place. Despite relatively strong gains by the major market indices, billions of dollars have been withdrawn from equities so far this year. Yieldless money market balances are very high and still more money has been flowing into bond funds. It is rare that contrarians are presented with such stark opportunities to avoid crowd behavior. So, we stay invested during frustrating periods. We remain cautious. We are committed to our long-term fundamental optimism about America and its future.

Michael K. Farr is President and majority owner of Farr, Miller & Washington, LLC. He is Chairman of the Investment Committee and is responsible for overseeing the day to day activities of the firm. Prior to starting FM&W, he was a Principal with Alex Brown & Sons.

Mr. Farr is a paid Contributor for CNBC television and has appeared on numerous broadcasts and has been quoted in global publications. He is a member of the Economic Club of Washington, DC, National Association for Business Economics, The World Presidents’ Organization, and The Washington Association of Money Managers. He is the author of "A Million Is Not Enough," and "The Arrogance Cycle."