Wall Street sees Knight as software risk wake-up call

Fri Aug 3, 2012 8:18pm EDT
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By Lauren Tara LaCapra and Dan Wilchins

(Reuters) - Wall Street banks and brokers are poring over their trading systems and rethinking the way they test software to make sure they don't become the next Knight Capital Group (KCG.N: Quote), the trading firm whose survival was imperiled by a software glitch on Wednesday.

Knight Capital's $440 million loss from errant trades, which has forced the company to consider selling all or part of itself, is the third time in five months that technical bugs have caused trouble for Wall Street players.

Executives at trading firms said they are debating among one another whether new regulations could prevent these snafus. But they also said glitches were a wake-up call for firms to improve their controls on their own, without being pushed into it. At a time when Wall Street is cutting costs, spending money on better systems to test software and manage risk could be an expensive proposition.

"We want to make sure that what happened to Knight doesn't happen to us," said the head of one investment bank. His company was looking carefully at how it tests new trading systems, to make sure traders know when new systems are being implemented and can be on the lookout for suspicious activity during those periods.

Their efforts face plenty of obstacles. As more trading has moved from exchange floors to computers over the last decade, the speed of execution jumped along with the potential for cascading problems.

Trading firms, market makers, brokers, investment banks, and exchanges and other trading venues are linked in a network of complex computer systems that compete to execute trades as fast as possible. That competition, combined with the never-ending array of new rules, forces market participants to constantly improve their systems.

But the intricate network of players and systems creates a much wider range of potential problems for trading systems, making testing costly and difficult. Good testing requires a firm to imagine everything that can possibly go wrong and how the system will interact with other systems. Predicting every plausible scenario is not easy, said one trading head at a major Wall Street firm.

Regulators have set up "circuit breakers" that require exchanges to suspend trading in stocks that move too much too quickly. But dealers and other market players usually have even more sophisticated circuit breakers for their own trading.   Continued...

A trader works at the Knight Capital kiosk on the floor of the New York Stock Exchange August 1, 2012. REUTERS/Brendan McDermid