Knight Capital Americas LLC agreed to pay a penalty of $12 million to settle the charges filed by the Securities and Exchange Commission (SEC) related to violating market access rules related to the company’s trading incident that disrupted the markets in August 1, last year.

SEC whistleblower United States

Knight capital’s investigation

The result of the investigation conducted by regulators found that Knight Capital did not have adequate safeguards to minimize the risks posed by its access to the markets. Regulators also discovered that the company failed to prevent the entry of millions of erroneous orders because of lack of defense mechanisms from such incidents.

In a statement, Andrew Ceresney, co-director of Division of Enforcement of SEC said, “The market access rule is essential for protecting the markets, and Knight Capital’s violations put both the firm and the markets at risk. Given the rapid pace of trading in today’s markets and the potential massive impact of control breakdowns, broker-dealers must be held to the high standards of compliance necessary for the safe and orderly operation of the markets.”

SEC on market malfunction

In addition, Daniel Hawke, chief of the Market Abuse Unit, Enforcement Division of SEC, emphasized that brokers and dealers are responsible for making sure that every component of their systems have safety nets to limit the damage it would cause to the markets in the event of malfunction. According to him, Knight Capital failed to ask the critical questions regarding its systems components, which led to catastrophic consequences.

According to SEC, Knight Capital made two critical technology missteps. The first mistake was moving a section of computer code in 2005 to an earlier point in the code sequence in an automated equity router. The move rendered a function of the router defective. The company left the function there even if it did not intend to use it.

Knight Capital’s retail liquidity program

The second problem was when the company was preparing to participate in the new Retail Liquidity Program of the NYSE Euronext (NYSE:NYX) in July 2012. Knight Capital mistakenly deployed new code in the same router. Some orders eligible for the NYSE program triggered the defective function in the router, which failed to determine the orders that had been filled.

As a result, Knight Capital’s router sent out more than 4 million orders into the market when attempting to fill just 212 orders 45 minutes after the market opened on August 1. During that day, Knight Capital traded more than 397 million shares and acquired unwanted positions worth several billions of dollars. Knight Capital incurred $460 million in losses from the technical glitch.

SEC explains violated market access rules

According to the SEC, Knight Capital violated market access rules because of the following reasons:

  • It does not have adequate controls, procedures for code deployment, or testing for equity order router.
  • It relied on financial risk controls incapable of preventing the entry of orders that exceeded pre-set aggregate capital thresholds for the firm.
  • It did not link the account that received executions to automated controls regarding the overall financial exposure of the firm in August 1.
  • It did not have enough controls and written procedures to guide employees in responding to significant technological and compliance incidents.
  • It failed to review its business activity adequately in connection with its market access to ensure the overall effectiveness of its risk management controls and supervisory procedures.
  • The company did not have sufficient description of risk management controls.
  • It failed to certify its risk management controls and supervisory procedures with the market access rules in its 2012 annual CEO certification.