Knight Capital
From Invertopedia, the encyclopedia of how things fail
Knight Capital was a US broker-dealer whose trading made up about ten percent of all trading in listed US stocks[1]. On August 1, 2012, its order router took 212 small customer orders and sent millions of orders into the market in about 45 minutes, ending up with billions of dollars of stock it never meant to own and a loss of over $460 million[1][2]. Within a week it needed a $400 million rescue that handed investors a 73 percent stake[4], and in 2013 it merged with GETCO into KCG Holdings[1][3].
Contents
The bet
Knight's router, called SMARS, could be updated in place for the New York Stock Exchange's new Retail Liquidity Program, which started on August 1, 2012[1]. The new code would replace an old, unused feature called Power Peg and reuse the flag that used to switch it on[1]. Knight believed that controls earlier in its order flow would catch bad orders, so the router itself had none that compared what went out with what came in[1].
What happened
| 2003 | Knight stops using Power Peg, but the code stays on its servers and can still be called.[1] |
|---|---|
| 2005 | Knight moves the part of Power Peg that counted filled shares to an earlier point in the code. Nobody retests Power Peg afterward.[1] |
| Jul 27, 2012 | Knight starts rolling out the new Retail Liquidity Program code to its eight SMARS servers. A technician misses one server, and no second person checks.[1] |
| Aug 1, 2012, 8:01 a.m. ET | Internal emails start flagging "Power Peg disabled." 97 of them arrive before the 9:30 open. Nobody acts on them.[1] |
| Aug 1, 2012, 9:30 a.m. ET | Orders with the reused flag hit the eighth server and trigger Power Peg, which never stops sending orders. In about 45 minutes Knight gets 4 million executions in 154 stocks, for more than 397 million shares.[1] |
| Aug 1, 2012 | Trying to fix it, staff remove the new code from the seven good servers. That makes all of them run Power Peg too.[1] |
| Early Aug 2012 | Knight puts its loss at about $440 million and says its capital base was "severely impacted."[5] |
| Aug 6, 2012 | Six firms, including Jefferies, Blackstone, TD Ameritrade and rival GETCO, put in $400 million for a 73 percent stake. Knight's shares fall 23 percent to $3.11.[4][6] |
| Jul 1, 2013 | Knight and GETCO combine to form KCG Holdings. Knight shareholders can take $3.75 a share in cash or one-third of a KCG share.[1][3] |
| Oct 16, 2013 | Knight settles with the SEC over the market access rule, without admitting or denying the findings, and pays a $12 million penalty.[1][2] |
The kill shot
One server never got the new code, and the old code it was still running had been broken for seven years. Nothing in the router could notice it was buying far more than it was asked to, and nothing could stop it.
The SEC found that Knight had no written deploy procedure for SMARS, no second-person review, and no rule for what to do with unused code on live servers[1]. Power Peg had last been used in 2003, and the 2005 change that broke it was never tested[1].
When it went wrong, there was no plan. The main risk tool, PMON, relied entirely on people watching it, sent no alerts and lagged under the load[1]. Knight stayed connected to the market while engineers tried to find the bug live, and their first fix spread it to every server[1]. By the time it stopped, Knight held a net long position of about $3.5 billion in 80 stocks and a net short position of about $3.15 billion in 74 stocks[1].
Red flags ignored
- Dead code left switched on. Power Peg had been unused for nine years but was still present and callable.[1]
- A flag with two meanings. The new feature reused the old feature's switch, so any server without the new code ran the old one.
- One person, no checklist. The deploy had no second reviewer and no written procedure.[1]
- Warnings nobody read. 97 emails naming Power Peg arrived before the open, but they were not designed as alerts and were not acted on.[1]
- Limits that did not stop anything. The account that soaked up the stray fills had a $2 million limit that was not linked to any automatic control.[1]
The cost
Over $460 million lost on unwanted positions[1][2]. For 75 of the stocks, Knight's trades were more than 20 percent of the volume and helped move prices by more than five percent, which hit other traders too[1].
To survive, Knight sold preferred shares convertible at $1.50 to a group of investors for $400 million, giving them a 73 percent stake[4]; Knight's stock had closed at $4.05 the Friday before the deal was reported[5]. A year later the firm was folded into KCG Holdings[1][3], and the SEC added a $12 million penalty and a cease-and-desist order[1][2].
The inversion
Delete code you no longer use, never give an old switch a new meaning, deploy to every server or none and check it, and build a kill switch that stops the system when what goes out does not match what came in.
What survived
The business, under new owners. Knight and GETCO became subsidiaries of KCG Holdings on July 1, 2013[1][3]. The SEC order became a reference case for its market access rule, Rule 15c3-5, which requires brokers to have automatic controls that block erroneous orders and orders over preset capital limits[1][2].
References
- ^ “In the Matter of Knight Capital Americas LLC (Release No. 34-70694)”. U.S. Securities and Exchange Commission, October 16, 2013. The primary record: market share, SMARS, Power Peg history (2003, 2005), the July 27 deploy and missed server, the 97 emails, 212 orders, 4 million executions, 397 million shares, positions, the over-$460 million loss, PMON, the botched fix, the 33 Account, price impact, the KCG merger date, the settlement and $12 million penalty.
- ^ “SEC News Digest, October 16, 2013”. U.S. Securities and Exchange Commission, October 16, 2013. The SEC's summary: over $460 million lost, 45 minutes, $12 million penalty, Rule 15c3-5.
- ^ “KCG Holdings, Inc. Form 8-K12G3”. KCG Holdings filing with the SEC, July 1, 2013. The merger completed July 1, 2013 and the $3.75 cash or one-third share election.
- ^ “Knight Capital gets $400 million rescue”. Reuters via Arab News, August 6, 2012. The $400 million rescue, the six investors, the 73 percent stake, the $1.50 conversion price and the 23 percent share fall to $3.11.
- ^ “Report: Knight secures $400M rescue from investors”. AP via News Tribune, August 6, 2012. Knight's early loss estimate of about $440 million, the "severely impacted" quote and the $4.05 Friday close.
- ^ “Knight Capital Group”. Wikipedia. The Jefferies-led group of about six investors in the rescue (cross-check).