Knight Debacle Calls for Regulatory Scrutiny—and Caution

US market-maker Knight Capital had a sterling name on Wall Street. In under an hour, that name was decimated. I'm still blown away by the speed at which this all transpired.

Hirander Misra, chairman of London-based Foreign Trading Solutions, says that as a result of what appears to be a technology glitch, Knight is likely done for, even as it is frantically scrambling for a lifeline.

"A reputation that you built up is eroded in a matter of seconds," he says. "It would be naïve to think they're going to be able to recover from this."

So now—barring a miracle—a sale or bankruptcy is in order. And tax implications will make a sale even more difficult, says George Michaels, CEO at financial tax software provider G2 Fintech.

"What's worse is they can't re-trade any of those securities for the next 30 days, because then you get wash sales. If they have those types of losses on the books, and they buy back any of those securities, those losses get disallowed," Michaels says. "If they have $440 million in losses in 150 stocks for which they are market-makers on the NYSE, and actively trade on any of those stocks in the subsequent 30 days, they're going to start triggering the wash sale left and right. That means they, or their acquirer, wouldn’t be able to take those losses from a taxable basis. That makes them kind of poisonous, for 30 days anyway."

There is no question that regulators and politicians will examine algorithmic—and specifically, high-frequency—trading with renewed vigor. And I think they’re right to do so.

In other words, Michaels says, if Knight were bought, traders at the acquiring firm wouldn’t be able to trade in those names for 30 days, either.

Another interesting thing to remember is that this is not the first time that Knight has had to weather a software glitch that brought it to the brink, as my colleague Tim Murray points out. I found this observation, made by Knight CEO Thomas Joyce in a 2006 Waters article, especially interesting: "Whenever there's a [regulatory or market] change, things can break your way if you're prepared. If you're not, you'll find yourself in a bad situation."

Indeed. 

Three Makes a Trend
Knight’s nightmare comes on the heels of Bats Exchange's failed IPO attempt and Nasdaq’s Facebook IPO problems—both results of technology problems. There is no question that regulators and politicians will examine algorithmic—and specifically, high-frequency—trading with renewed vigor. And I think they’re right to do so.

The regulators might get some help from inside the industry. While defending his company, New York Stock Exchange CEO Duncan Niederauer stated today during a conference call that "speed is not always better" and that the market is "broken.”

Still, I think the regulators and market participants must be careful not to throw the baby out with the bathwater. The bathtub, though, clearly needs to be improved.

As my colleague Jake Thomases pointed out in this week's Sell-Side Technology editor's letter, there is still much we don’t yet know about what, exactly, went wrong. As a result, the bull's eye has been placed squarely on algorithmic trading. As Jake wrote—and I agree—algorithmic trading itself is not the problem: How it is used, and where things go wrong, must be examined.