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Knight Capital’s Cautionary Tale

August 3, 2012

Knight Capital Group’s massive $440 million trading loss is being blamed on a software glitch from a new trading system that sent a stream of bogus trades for a half hour before it was finally shut down.

The firm, which largely does business by executing trades on behalf of other brokerages, has shaken the confidence of many of its clients and could see them heading for the exits after Thursday’s losses. However, it’s just the latest in a series of technical glitches that have rocked the increasingly automated securities trading industry since the so-called “flash crash” of 2010.

Such systems need to be properly tested and a firm needs to be able to shut it down quickly in the event of irregular activity. An “audit trail” that the Securities and Exchange Commission is beginning to require may allow them to trace back the events that led up to the system failure. Such systems also need to be able to adapt to regulatory changes. Many trading systems had to be adapted this week to adjust to a new retail order-taking exchange at the New York Stock Exchange along with a new securities transaction tax in France that became effective on Wednesday, Reuters pointed out.

With more countries considering the possibility of levying taxes on securities transactions, as in the U.K. proposal for the so-called “Tobin tax,” suggested by Nobel-winning economist James Tobin, trading systems will need to need to be robust enough to keep track of such taxes, charge the taxes to their customers’ accounts, allocate them to the proper authorities, and execute the trades, all in a matter of milliseconds.

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