Are the high-profile technical glitches experienced by firms like Knight Capital, Nasdaq and BATS actually good for the health of the capital markets?

Some experts think so.

The first major blowup came when alternative-trading firm BATS priced it IPO, only to withdraw it after a disastrous technical glitch. Then came Nasdaq OMX Group (NDAQ) experiencing major system problems when it was inundated with orders for Facebook (FB) shares during the IPO. Most recently, a glitch at Knight Capital Group (KCG) caused chaos with stock trades, nearly bringing the firm down.

Surely ugly for the companies involved, all of these issues are examples of what can go wrong without proper risk procedures in place. 

“What happened at Knight Capital will prove to be great for capital markets,” said Harpal Sandhu, co-founder and CEO of Integral Development Corp., a firm that develops risk management, analysis and foreign exchange trading software used by many different institutions, including major banks. “You better believe every firm like Knight Capital is looking at their systems and making sure things are in order.”

Sandhu believes that after a debacle along the lines of Knight Capital, everyone learns from it and, as a result, the marketplace gets stronger.

Wall Street firms are using computer systems to replace humans more than ever before, to be more competitive as firms get hammered by the economic downturn. These systems work more efficiently and faster than humans. More and more firms have entered the market to allow investors new avenues to trade stocks.  

Industry observers say what is so astonishing is just how quickly technology has been implemented in different areas within Wall Street firms. Entire firms that used to play a part in the market-making puzzle have been wiped out by technology and now the processes are done at the fraction of the cost and time.

“What we saw is equity automation really accelerate in the 2002 period as commissions came down dramatically,” said Brad Hintz, banking analyst at Stanford Bernstein. “Now we are seeing fixed-income become more automated.”

Morgan Stanley is reportedly looking to lay off several fixed-income traders and replace them with computers to cut costs, and Goldman Sachs has reportedly spent millions investing in new systems in the last few years. Goldman Sachs CFO David Viniar has publicly said that slightly more than 25% of all the firm’s employees are in the technology and IT space.  

“Most of the big banks and brokerages are spending 20-25% of their expense budget on technology,” said David Hilder, bank analyst for Drexel Hamilton.  “All of these tech problems and general failures of risk management have certainly caused every bank to think more intensely about operational risk.”

Another factor for more risk is that each of these firms has many different systems throughout, all of which need specific technology. And many are custom built, making it more difficult to keep compliance and checks in place.

“Frankly, there are so few of the large investment banks left, it doesn’t make sense to develop an off the shelf system to market to these banks,” said Hilder.  

In late 2009, the Securities Exchange Commission introduced the Market Access Rule to ensure financial firms have the proper risk controls in place. The rule requires brokers and dealers to have risk controls in place before giving customers access to the market. It requires brokers to place risk management controls and supervisory procedures in place to prevent erroneous trades.
The Market Access Rule was just being applied when Knight Capital’s technical glitch hit, causing sudden swings in stock prices and a surge in trading volume. The issue took almost an hour to be discovered and was ultimately stopped, but not before costing the firm $440 million. The mistake caused Knight Capital’s stock price to drop by 75% in just two days. 

Of the 140 stocks impacted, the SEC reversed trades in only six cases.

“The best thing the SEC did was to make Knight stick to those trades,” said James Angel, a finance professor at Georgetown University, and a director for Direct Edge, a computer-driven stock exchange in which Knight Capital is a shareholder. “That sends a very strong signal to every trading firm that they need to make sure nothing goes wrong, nothing fails.”

With new financial technology, regulators need to ensure that everyone in the market place has the right systems in place. But experts say it’s impossible to have every scenario covered.

“This is the nature of technology,” said Angel. “Mistakes will happen again, so we need to protect ourselves and when it happens we know how to deal with it.”

Basic trading programs monitor trading positions and profit and loss. When the system generates an order, if the order is larger than average, an alert is typically generated.  The solution towards better technology systems with good checks and balances is better risk management, experts say.

“These mistakes are a wake-up call and ultimately good for markets,” said Sandhu. “It forces firms to focus on operational risk management, focus on testing and the release test process.”

The fundamental culture shift is happening on Wall Street with more and more firms opting to bring in technology experts in leadership positions.  One recent example is the CME changing their leadership to focus more on technology.  CME CEO Craig Donohue, a lawyer by profession, was recently replaced by Lupinder Gill, the firm’s technology leader.

But not everyone is convinced automated computer systems are the answer.

“The firms that are going to win are the firms that are living and breathing technology,” said Sandhu.