Did Weak Controls Contribute to Knight's Trading Loss?

U.S. regulators are working to figure out whether the trading snafu at Knight Capital Group that resulted in a $440 million loss and nearly destroyed the firm was exacerbated by a breakdown in risk management, according to a source familiar with the situation.

A team of U.S. Securities and Exchange Commission's trading and markets division staff and the Office of Compliance Inspections and Examinations are focused on trying to uncover what happened and whether the problem should have been caught, said the source, who declined to be identified because the individual is not allowed to talk to the press.

One of the questions being asked by the SEC is why there appeared to be a breakdown in controls. There was no single point person at Knight to deal with the problem when it occurred, leading to further confusion and extending the time it took to stop the flow, according to a second source.

A spokesman for the SEC declined to comment on the nature of the investigation, instead referencing an August 3 SEC statement on the matter that said there were rules in place that should have prevented the problem.

Knight's trading glitch was the result of old software that was somehow activated, unleashing a flood of errant trades into the stock market on Aug. 1. The software problem at Knight caused the firm to buy and sell about 150 different stocks over 30 to 45 minutes, amassing a $7 billion position it later had to unload at a loss.

The amount of time it took the firm, along with NYSE Euronext, which operates the New York Stock Exchange, to halt the flow of errant trades has brought Knight's risk management procedures into question.

NYSE could have halted Knight's entire order flow to the exchange, but that would have affected many legitimate orders as well, said the second source. In the end, it took steps by both Knight and NYSE to stop the flow of bad trades.

Reuters previously reported that Knight's market-making group was having difficulty isolating the problem in order to halt the trading.

Knight Capital was the largest U.S. retail market maker in 2011. Market makers buy and sell shares on behalf of clients and step in to provide liquidity using their own capital. The trading program was the latest technology snafu to overwhelm a market dominated by high-speed trading.

Knight's software was being updated in time for the August 1 launch of the NYSE's retail liquidity program, designed to improve pricing for retail investors and also take market share away from market makers.

Staff in the trading and markets division and the Office of Compliance Inspections and Examinations worked through the weekend following the August 1 incident to figure out what caused the trading disruption at Knight, according to the first source.

Shares of Knight's stock have been hit hard since the event, falling around 72 percent. The shares were down 3.4 percent at $2.85 on Thursday.

Data from Thomson Reuters Autex shows that Knight has regained most of the market-making share it lost in the wake of the trading debacle.