How Knight Capital Lost $440 Million in 45 Minutes

Knight Capital’s $440 million loss happened on August 1, 2012, when a botched software deployment left a decade-old, broken piece of code active on one of the firm’s order-routing servers. Over the first 45 minutes of trading, that server flooded U.S. exchanges with millions of unintended orders. When Knight unwound the resulting $7 billion in accidental positions, the pre-tax loss came to roughly $440 million, a figure the SEC later put above $460 million.¹²

Knight was one of the largest market makers in U.S. equities at the time, executing trades for brokers such as TD Ameritrade and E*Trade and handling about 11 percent of all U.S. stock trading in the first five months of 2012.¹ The disaster nearly destroyed the firm in a single morning.

What Happened in Those 45 Minutes

At 9:30 a.m. Eastern on August 1, 2012, Knight’s automated trading system began sending orders into the market at a pace no human could match. Over the next 45 minutes, the firm’s systems transmitted more than 4 million orders while trying to fill just 212 legitimate customer orders.² Those messages resulted in executed trades involving roughly 397 million shares across about 154 different securities, leaving Knight with approximately $7 billion in unintended long and short positions.³

The bleed rate was roughly $10 million per minute. When Knight later unwound the accidental positions by selling the overvalued shares back into the market at lower prices, the firm absorbed a pre-tax loss of approximately $440 million. That single-morning loss exceeded Knight’s entire revenue for the previous quarter, which was $289 million.¹

The Technical Cause: Dead Code Brought Back to Life

The failure grew out of a chain of decisions stretching back nearly a decade inside Knight’s order-routing software, known as SMARS.

SMARS contained a function called Power Peg, originally used to manage the execution of child orders sent out to fill a larger parent order. A built-in counter tracked how many shares had been filled and stopped routing once the parent order was complete. Knight stopped using Power Peg in 2003, but no one ever removed the code from the production environment.⁴

In 2005, engineers made a separate change to SMARS that moved the cumulative-quantity tracking function to an earlier point in the code. The change inadvertently broke Power Peg’s internal counter. Because no one was using Power Peg, no one noticed. The code sat dormant and defective for seven years.⁴

The trigger came in the summer of 2012. In early June, the SEC approved the New York Stock Exchange’s new Retail Liquidity Program, which offered individual investors better pricing on their trades and introduced a new order type. Firms wanting to participate had to write and deploy new software. The program was scheduled to go live on August 1.⁵ Knight’s engineers deployed the new code to the firm’s production servers between July 27 and July 31.³

The update reached seven of Knight’s eight SMARS servers. One was missed. The new code repurposed an internal flag that had once been used to activate Power Peg. When markets opened on August 1, the un-updated server read incoming Retail Liquidity Program orders as a signal to run the old Power Peg function.³ With the cumulative-quantity counter no longer working, the server had no way to recognize when orders had been filled. It kept sending child orders in rapid sequence, without limit.⁴

Why Nobody Stopped It Sooner

Before markets even opened that morning, an internal Knight system generated 97 automated emails flagging an error tied to the code deployment. Those warnings went unacted upon.²

Once trading started and the orders began pouring out, Knight had no kill switch or comparable override that could instantly shut down the malfunctioning system.³ The SEC later found that the firm relied on manual monitoring, had no pre-trade controls comparing outgoing orders against entered orders, and had no written incident response procedures to follow during a major technology failure.²

The Damage Beyond the Trading Loss

Knight’s stock fell 32 percent the day of the incident and another 63 percent the next day, closing at $2.58. The two-day drop came to roughly 75 percent.¹ CEO Thomas Joyce told CNBC, “We screwed up… we paid the price,” and confirmed he had spoken with SEC Chairman Mary Schapiro about whether any of the trades could be canceled.⁶ Knight said no customer orders were harmed by the errant trades.

With its capital badly impaired, Knight had five days to find a rescue. On August 6, the firm announced a $400 million emergency capital infusion from a consortium including Jefferies, Stifel Financial, TD Ameritrade, Blackstone, and Getco. Knight issued preferred stock convertible into 267 million common shares at $1.50 per share, diluting existing shareholders by more than 73 percent.⁷

What Happened to Knight After the Rescue

In December 2012, Knight agreed to be acquired by Getco, a Chicago-based high-frequency trading firm and one of the August rescue investors, in a deal valued at $1.4 billion.⁸ Shareholders of both firms approved the deal in late June 2013, and the combined company began trading on the NYSE as KCG Holdings, Inc.⁹

Joyce had argued for Knight to remain independent. Two days after the merger closed on July 1, 2013, he resigned. In an email to the board he wrote that once independence was off the table, the Getco merger “was the best alternative available to Knight shareholders and other key stakeholders.” Getco co-founder Stephen Schuler replaced him as chairman, and former Getco CEO Daniel Coleman became chief executive.¹⁰

KCG later sold its NYSE designated market-making business to Citadel Securities in February 2016.¹¹ On April 20, 2017, KCG announced an agreement to be acquired by Virtu Financial for $20 per share in cash, a 46 percent premium over its recent trading price.¹² The deal closed on July 20, 2017 for approximately $1.4 billion, ending the Knight Capital lineage as an independent entity.¹³

SEC Penalty and Shareholder Settlement

On October 16, 2013, the SEC announced that Knight Capital Americas LLC had agreed to pay a $12 million penalty to settle charges of violating Rule 15c3-5 under the Securities Exchange Act, the Market Access Rule. It was the first enforcement action the SEC had ever brought under that rule, which was adopted in 2010 and requires broker-dealers with direct exchange access to maintain adequate pre-trade risk controls and supervisory procedures.²

The SEC identified specific failures:

No controls at the point of order submission to compare outgoing orders against entered orders, which would have caught the flood of duplicates.
Financial risk controls that were not linked to the specific account involved in the August 1 trading, leaving aggregate capital limits ineffective.
Reliance on manual monitoring and no action taken on the 97 automated error emails generated before the market opened.
No formal written procedures to guide employees through a significant technology failure.
No requirement for a second technician to verify code deployments and no mechanism to confirm that all servers received the same update.
An annual CEO certification that stated “processes” existed rather than affirming that controls were reasonably designed to comply with the rule.²

Knight consented to the order without admitting or denying the SEC’s findings. Beyond the fine, the firm was censured, ordered to cease and desist from further violations, and required to retain an independent consultant to review its risk controls.²

Shareholders sued separately. In Louisiana Municipal Police Employees Retirement System v. Knight Capital Group, Inc., filed in the U.S. District Court for the District of New Jersey, investors alleged the company had made misleading statements about its risk management and internal controls during a class period running from May 10, 2011 through August 1, 2012. The complaint cited the $461 million trading loss, a $143 million impairment charge, and the loss of more than $750 million in market capitalization over two trading days.¹⁴ A federal judge preliminarily approved a $13 million settlement in March 2015,¹⁵ and final judgment was entered on July 6, 2015.

1
The New York Times. Knight Capital Says Trading Mishap Cost It $440 Million
2
SEC. Knight Capital Agrees to Pay $12 Million Penalty
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PRMIA. PRMIA Case Study – Knight Trading
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SEC. In the Matter of Knight Capital Americas LLC (Administrative Proceeding)
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CIO. Lessons Learned From Knight Capital Fiasco
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CNBC. CNBC Transcript: Knight Capital Chairman and CEO Thomas Joyce
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CNBC. Knight Defies Too Big to Fail Trade
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CNBC. Knight Capital Group to Cut Workforce by 5 Percent
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SEC. KCG Holdings Registration Statement (Form S-4)
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The New York Times. Knight Capital Chief Quits
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Institutional Investor. The 2016 Tech 50: Daniel Coleman
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SEC. KCG Holdings Announcement of Definitive Merger Agreement
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Traders Magazine. Virtu Financial Deal to Acquire KCG Closes
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Saxena White. Knight Capital Group, Inc.
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Law360. KCG Pays $13M to End Investors’ Suit Over $460M Glitch