Knight Capital, the New Jersey based brokerage, has agreed to pay the US Securities and Exchange Commission $12m after the regulator fined it for a major trading technical malfunction, which caused the prices of 140 stocks listed on the New York Stock Exchange to fluctuate wildly, in August last year.
The SEC said the firm ignored dozens of error messages and did not have adequate safeguards in place to limit the risks posed by its access to the markets and therefore failed as a result to prevent the entry of millions of erroneous orders.
"Brokers and dealers must look at each component in each of their systems and ask themselves what would happen if the component malfunctions and what safety nets are in place to limit the harm it could cause," said Daniel M. Hawke, chief of the SEC Enforcement Division's Market Abuse Unit.
"Knight Capital's failure to ask these questions had catastrophic consequences."
Major Trading Malfunction
On 1 August, a technical system malfunction caused the prices of 140 NYSE-listed stocks to fluctuate wildly, leaving Knight Capital with a $460m (£287m, €338m) loss.
"The market access rule is essential for protecting the markets, and Knight Capital's violations put both the firm and the markets at risk," said Andrew Ceresney, co-director of the SEC's Division of Enforcement in a statement.
"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."
Less than a week after the event, the brokerage said it had arranged a $400m bailout through a group of investors to buoy up its balance sheet.
The $400m equity financing deal was completed through a raft of Wall Street giants, including the Jefferies Group, which conceived and structured the investment, as well as Blackstone, GETCO, Stephens,Stifel Financial Corp. and TD Ameritrade Holding Corporation.
"We are grateful for the support of these leading Wall Street firms that came together to invest in Knight," said Tom Joyce, Chairman and Chief Executive Officer, Knight Capital Group at the time.
"The array of participants in this capital infusion underscores Knight's critical role in the capital markets. With our financial position strengthened and liquidity restored, we will continue to provide clients with trading in a broad range of securities, high-quality execution and outstanding client service."
How It Happened
According to the SEC's order, Knight Capital made two critical technology missteps that led to the trading incident on 1 August last year:
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.
Although this function was not meant to be used, Knight left it in the router. In late July 2012 when preparing for participation in the NYSE's new Retail Liquidity Program, Knight Capital incorrectly deployed 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.
During the first 45 minutes after the market opened on August 1, Knight Capital's router rapidly sent more than 4 million orders into the market when attempting to fill just 212 customer orders.
Knight Capital traded more than 397 million shares, acquired several billion dollars in unwanted positions, and eventually suffered a loss of more than $460m.