[SagelyGuru]

'Prediction is difficult, especially with regard to the future'.

It looks like they were using some new algorithm, which should have made them a lot of money, had the market gone up after their massive purchases. In that case, they would have pocketed fat bonuses and would not be on the news.

However, it has not happened, so the crying and the search for a scapegoat is on. It sounds like the case of the banking business as usual: 'heads I win, tails you lose'.

Ultimately, there is a really serious problem with the concept of limited personal liability for companies engaging in speculation. It is an assymetric arrangement, whereby the directors are entitled to the profits but are never personally responsible for the losses. With such rules of the game, it is advantageous to take crazy risks. Expect to see a lot more of this and many more taxpayer funded bailouts.

[yummyfajitas]

Huh? Knight Capital lost a bunch of money, and will likely go bankrupt. Essentially, Knight's software bug transferred a bunch of money from Knight to everyone else. This poses minimal systematic risk to anyone else, and they will almost certainly get no bailout.

The markets have already recovered. The S&P was down a little bit on thurs and recovered by friday. Knight is down 60%.

http://www.google.com/finance?q=INDEXSP%3A.INX%2C+NYSE%3AKCG

This is ultimately a situation of the market being a robust and stable dynamical system.

[white_devil]

> This is ultimately a situation of the market being a robust and stable dynamical system.

Not while it's being shaped by algorithms competing against each other, which you're a part of.

[gkuan]

Yes, no risk to others unless you happen to be one of their newly acquired futures broker unit's customers with $411 million in deposits. http://www.reuters.com/article/2012/08/02/knightcapital-regu...

[yummyfajitas]

Did you read the article you just linked to? Penson's customers have their money in accounts completely segregated from Knight's electronic trading division.

"It isn't like we found out that Knight was stealing money," Sommers [a CFTC commissioner] said.

The CFTC is just watching carefully to make sure it stays that way.

[gkuan]

Actually, don't get me wrong. I think HFT is great (and I thought your HFT Apologist series was excellent). It reduces spreads greatly. There is nothing intrinsically wrong with prop firms, market makers, etc. But it is also an increasingly complex system and risk is part of the business. My meta-point (certainly not particular to Knight) is I don't think we understand all the consequences or the risks yet stemming from the fairly saturated and very competitive business, and the continuing arms race. There is also that unpredictable and fallible human component and how it reacts or affects the automated agents. There was even a paper on how as we approach zero, there may be brand new "relativistic" arbitrage opportunities: http://www.alexwg.org/publications/PhysRevE_82-056104.pdf. The Knight incident seems to me a reminder that there is much more to be done in risk management, more robust modeling, and defensive software development technologies in fintech. I don't know when the incentives will be there to invest in such things.

[gkuan]

Yes, exactly, but it is still risk. They certainly haven't lost their money yet. If everything works out right, they shouldn't have to. But the financial world is much too complicated to say that there is minimal risk for any party, even if everything is in Treasury bonds.

[gkuan]

Moreover, I would suggest you read Johnson et al's research on mini-flash crashes (http://arxiv.org/pdf/1202.1448.pdf) if you hold that the markets are stable dynamical systems.

[yummyfajitas]

How does this research suggest the market is unstable? According to these authors, the market was (in their view) dangerously perturbed 18,520 times, more than once per day. In spite of that, it remained stable. The flash crash took an afternoon to recover from. Knight took a day.

If you perturb a system over and over and each time it quickly swings back to equilibrium, that's pretty strong evidence it is stable.

[iskander]

They weren't taking long-term speculative positions, their short-term market making had a major bug in which instead of buying low and selling high it was doing the opposite (thus losing a small amount on each pair of trades). For more details read Nanex's blog (http://www.nanex.net/aqck2/3522.html).

So, they launched a busted market making algorithm, lost a ton of money and no one is going to bail them out.

[jonah]

And the nanex guess at why it happened: http://www.nanex.net/aqck2/3525.html

[wtracy]

"We think the two periods of time when there was a sudden drop in trading (9:48 and 9:52) are when they restarted the system. Once it came back, the Tester, being part of the package, fired up too and proceeded to continue ..."

Ouch!

[SkyMarshal]

Worse dumb mistake I've ever made was to accidentally send a test email to several thousand live customers instead of the test accounts. That was a sinking feeling.

But creating a bug that loses your company half a billion dollars in thirty minutes and bankrupts them, must be stomach-churning.

[davidmr]

Much, much worse than the bug in the market making algorithms was the design failure of not having some out-of-band mechanism to kill order traffic (or of said mechanism's failure to be tested adequately).

This is a risk management failure much more than a programming error.

[bjork]

I love dumb coders!

[justincormack]

They were not taking big positions expecting the market to go up, they appear to largely have been burning money buying and selling fast.

There is no government money involved.

[SagelyGuru]

Of course, buying high and selling low is always the 'reason' for making a loss. In this case, I think the program caught itself out by manipulating the market, which it perhaps naively assumed to be non-manipulable.

In other words, it was creating so much volume that, when buying (or selling), it made the market go up (or down). It was then reading the price as going up (or down) and jumping on its own bandwagon. This, of itself, would create growing oscillations in the market and growing losses.

For this to work for you, you need to first create a trend and then sit back and let the suckers pile in on it and take the losses. You then return only when you want to reverse the trend again, at a profitable level (for you). I suspect the program was just too fast for its own good and not a match for the human Masters of this art.

[beagle3]

That's not what happened, according to nanex.

It just kept making markets in reverse (instead of joining the bid and the offer, it bid on the offer and offered on the bid).

Nanex speculates that Knight ran their tester software on the real market (the tester losing money on purpose to the main algorithm). Alternatively, it could simply be a bug that sends a bid instead of an offer and vice versa. One bit flip at the wrong place could cause that.

[ams6110]

Guess their developers never watched "Trading Places"....

"Wilson!!! Get back in there and SELLLLLLLL"