2012/08/07

Knight in soiled armour

Last week the markets experienced another little jolt, similar to the flash crash in 2010. A computer glitch at Knight Capital caused its systems to send out incorrect orders, causing huge price swings in stocks and driving the company nearly to bankruptcy.

Bugs

There is now talk of changing regulations (again) and everyone wonders what Knight Capital did wrong. They had a bug. I cannot be certain, but my guess is that whatever software they were using had been tested. But with sophisticated systems bugs always slip through (it’s inevitable). Unluckily for Knight their particular bug caused a lot of trouble and damaged the company’s reputation, possibly irreparably.

It’s (almost) all in the mind

What is interesting is that the company is set to survive. Knight was bailed out not by government, but by a handful of its competitors – perhaps they know this could just as easily have happened to them. They were not just being helpful, though. They saw an opportunity to buy a large stake of a good business (potentially good, in any case) very cheaply. The major obstacles to Knight’s continued survival were a lack of capital and loss of confidence. Both were addressed by the bailout. The very fact that these companies were willing to fund Knight will give the market assurance that the business was worth saving.

Reputations

This bailout comes at a price to current shareholders (who are the ones who should pay – not taxpayers and not clients) whose holdings are diluted. Perhaps, slowly, clients will return. The key reason to think this may happen is the reputation of Knight’s CEO, Thomas Joyce, which seems to have been both battered and uplifted in the debacle. Unlike Bob Diamond, CEO of Barclays and other banks’ top brass, Joyce’s integrity is not in question. He has been called a hero for managing to get hold of the much needed financing. Knight also, it seems, absorbed most of the losses – shielding their clients.

What is in question is Knight’s risk management and software testing. And after an incident like this, I think this is liable to become too strict rather than too relaxed. They cannot afford another incident – that would almost certainly end them, if not through a direct loss, then due to a loss of confidence.

Operational risk 

Knight’s problems highlight, once again, that the major risk in business, any business, is operational. It is unpredictable, its costs can be little or gigantic. Even with good risk management procedures (which are a must – and there is no reason to believe Knight’s were not adequate) mistakes will be made. The regulatory reactions to this will (probably) be firstly to increase the amount of capital that companies need to hold so they can absorb operational losses, secondly to mandate more stringent risk management, and thirdly to demand more detailed reports to the regulator (in this case the SEC). All of these things have their costs.

People will, of course, be very interested in knowing what exactly caused the software malfunction and how. And what Knight will be doing to prevent it from happening again. But what the error was hardly matters – it was random. Next time it will be something else. Hopefully responses will focus less on the specific nature of the problem that arose and more on the general nature of operational risk, which has a tendency to pop up in unexpected places.

References
  • Kisling, W., & Mehta, N. (2012). Joyce Puts Knight Survival Over Shares in Rescue Deal. Bloomberg. Retrieved August 7, 2012, from http://www.bloomberg.com/news/2012-08-06/joyce-puts-knight-survival-over-shares-forging-400-million-deal.html
  • Pratley, N. (2012). Knight Capital’s computer “glitch” shows dangers of desire for faster trading. The Guardian. Retrieved August 7, 2012, from http://www.guardian.co.uk/business/nils-pratley-on-finance/2012/aug/06/knight-capital-computer-glitch-trading?newsfeed=true
  • Reuters. (2012). Knight Capital handed $400m lifeline after trading debacle. The Guardian. Retrieved August 7, 2012, from http://www.guardian.co.uk/business/2012/aug/06/knight-capital-400m-lifeline
  • Sapa-AP. (2012). Knight Capital’s $440m computer glitch. Times Live. Retrieved August 7, 2012, from http://www.timeslive.co.za/scitech/2012/08/03/knight-capital-s-440m-computer-glitch
  • The Economist. (2012). Desperate times. The Economist. Retrieved August 7, 2012, from http://www.economist.com/blogs/schumpeter/2012/08/knight-capital?fsrc=scn/fb/wl/bl/desperatetimes
  • Touryalai, H. (2012). Knight Capital: The Ideal Way To Screw Up On Wall Street. Forbes. Retrieved August 7, 2012, from http://www.forbes.com/sites/halahtouryalai/2012/08/06/knight-capital-the-ideal-way-to-screw-up-on-wall-street/

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