Errant Trades Reveal a Risk Few Expected

The trading firm Knight Capital recently rushed to develop a computer program so it could take advantage of a new Wall Street venue for trading stocks.

But the firm ran up against its deadline and failed to fully work out the kinks in its system, according to people briefed on the matter. In its debut Wednesday, the software went awry, swamping the stock market with errant trades and putting Knight's future in jeopardy.

The fiasco, the third stock trading debacle in the last five months, revived calls for bolder changes to a computer-driven market that has been hobbled by its own complexity and speed. Among the proposals that gained momentum were stringent testing of computer trading programs and a transaction tax that could reduce trading.

In the industry, there was a widespread recognition that the markets had become more dangerous than even specialists realized.“What is starting to become clear is that the costs in terms of these random shocks to the system are occurring in ways that people never anticipated,” said Henry Hu, a former official at the Securities and Exchange Commission and a professor at the University of Texas in Austin.

Knight, founded in 1995, is a leading matchmaker for buyers and sellers of stocks, handling 11 percent of all trading in the first half of this year, according to the data firm Tabb Group. Knight lost three-quarters of its market value in the last two days, in addition to losing $440 million from the errant trades, and was scrambling to find financing or a new owner.

While the turbulence on Wednesday hit scores of individual stocks, the broader market took the spasm in stride, closing down less than 1 percent on Wednesday and Thursday. The S.E.C., which has opened an investigation into potential legal violations at Knight, said it was “considering what, if any, additional steps may be necessary.”

Some S.E.C. officials are pushing new measures that would force firm s to fully test coding changes before their public debut, according to a government official who spoke on the condition of anonymity. While the idea has long been discussed at the agency, it gained traction after the Knight debacle.

The S.E.C. applied limited safeguards on trading after the “flash crash” of 2010 sent the broader market plummeting in a matter of minutes. But big investors like T. Rowe Price, members of Congress and former regulators said Thursday that the S.E.C. and the industry had been too complacent and needed to do more to understand and control the supercharged market.

“Things are happening far too regularly,” said Ed Ditmire, an analyst at Macquarie Securities who focuses on stock exchanges. “It's not nearly as solid a market as it should be, so there's plenty of room for improvement.”

Arthur Levitt Jr., a former chairman of the Securities and Exchange Commission, said that recent events “have scared the hell out of inves tors” and called for the agency to hold hearings.

“I believe this latest event was handled better than the flash crash, but the larger question is whether our markets are adequate to deal with the technology that is out there,” Mr. Levitt said. “I don't think they are.”

Regulators have made changes to the markets over the last two decades that have taken it out of the hands of a few New York institutions and allowed dozens of high-frequency trading firms and new trading venues to dominate the stock market.

The high-speed firms like Knight, which connect directly to the servers of the exchanges and are capable of executing thousands of trades a second, are responsible for more than half of all activity in American markets. Companies that have benefited from the fragmentation and computerization of the markets have largely managed to fend off tighter controls by pointing to the steady decline in the cost of trading stocks.

Some large, institut ional investors, like Vanguard, have said that the increased volume of trading has made it easier to get in and out of stocks, lowering the ultimate costs for individuals who invest in popular vehicles like mutual funds.

But even people who had previously defended the advances in trading technology said on Thursday that too many problems had been overlooked.

In Knight's breakdown on Wednesday, as well as in the botched initial public offerings of Facebook in May and BATS Global Markets in March, the problems were caused by new computer programs that had not been adequately tested. Currently regulators have no protocol for signing off on new software programs like the one Knight rolled out.

“When they put these things out in the world they are really being tried for the first time in a real-life test,” said David Leinweber, the head of the Center for Innovative Financial Technology at the Lawrence Berkeley National Laboratory. “For other complex system s we do offline simulation testing.”

Mr. Leinweber has suggested to the S.E.C. that it do this work with the help of the supercomputing facilities at his center. The S.E.C. has recently moved in this direction by contracting with a high-speed trading firm that will provide it with more up-to-date market information.

Other changes to the markets would help slow trading during crises. Before computer trading became dominant, if a flood of unusual orders came in, they would usually be questioned by human order matchers, called specialists, working on the floor of the New York Stock Exchange.

To mimic that role, regulators are introducing a circuit breaker called the “limit up, limit down.” This forces a pause in trading of a stock if it starts occurring outside a normal price range. The mechanism will start in February.

“Quite literally, it could have stopped the flash crash,” said Gus Sauter, the chief investment officer at Vanguard.

The S.E.C. did introduce some circuit breakers after the flash crash but they stopped trading in only five of the stocks that were hit by Knight's faulty program.

Some critics of the current market structure have said that much bolder reform is needed. One change that has been contemplated is a financial transaction tax, which would force firms to pay a small levy on each trade. At the right level, this could pare back high-frequency trading without undermining other types, supporters say.

“It would benefit investors because there would be less volatility in the market,” said Representative Peter DeFazio, a Democrat of Oregon. He introduced a bill containing a financial transaction tax last year, but it has not found support.

Opponents of such a levy say that it could hurt the markets and even make it more expensive for companies to raise capital.

“I would be very concerned about unintended consequences,” said Mr. Sauter.

But Representative DeFazio, who favors a levy of three-hundredths of a percentage point on each trade, says he thinks the benefits of high-frequency trading are overstated. “Some people say it's necessary for liquidity, but somehow we built the strongest industrial nation on earth without algorithmic trading,” he said.

Benjamin Protess and Jessica Silver-Greenberg contributed reporting.