Knight Capital's order router sent millions of unintended orders in 45 minutes

What happened

Knight changed its software to take part in the New York Stock Exchange’s Retail Liquidity Program, which began on August 1, 2012. The new code was meant to replace an old function in the order router called Power Peg, which Knight had stopped using years earlier but had left in place, and it reused the flag that used to switch Power Peg on [1].

Starting July 27, Knight deployed the new code in stages. One technician did not copy it to one of the eight servers. No second technician reviewed the deployment, and Knight had no written procedure requiring one [1].

On August 1, orders carrying the repurposed flag reached the eighth server and set off the old Power Peg code. In 2005 Knight had moved the part of that code that counted how much of an order was already filled, and had not retested it. The server therefore kept sending child orders for each incoming order without regard to how much had already been executed. One part of Knight’s system recognized the orders as filled, but that information was not communicated to the router [1].

The result was more than 4 million executions in 154 stocks, more than 397 million shares, in about 45 minutes [1]. The SEC says the executions moved prices: in 75 stocks Knight’s trading was more than 20 percent of volume and contributed to price moves above five percent, and other market participants received less favorable prices in some cases and more favorable ones in others [1].

Knight’s August 2 statement attributed the orders to a technology problem related to installing trading software [3].

Where the knowing was missing

Beginning around 8:01 a.m. ET, an internal system generated automated emails, called BNET rejects, that referenced the router and an error described as “Power Peg disabled.” It sent 97 of them to a group of Knight personnel before the 9:30 a.m. open. The SEC says Knight did not design these messages as system alerts and personnel generally did not review them, but that they were sent in real time, were caused by the deployment failure, and gave Knight a potential opportunity to find and fix the problem before the open. They were not acted on before the open and were not used to diagnose the problem afterward [1].

While Knight’s technology staff worked to find the cause, the firm stayed connected to the markets and kept sending orders [1].

The outcome

The SEC’s order finds that Knight violated Rule 15c3-5, the market access rule, which requires controls reasonably designed to limit the risks of market access, including from automated systems. It was the SEC’s first enforcement action under that rule. Knight agreed to pay a $12 million penalty and to retain an independent consultant to review its controls [1] [2].