knight

In Knight Capital fiasco, a flurry of rule changes

August 8, 2012: 2:40 PM ET

An increase in stock trading rule changes is making it hard for firms to keep up.

FORTUNE -- Perhaps the only thing moving faster than high-frequency traders are the changes to the rules that govern how they trade.

On the day of the flub that cost Knight Capital Group (KCG) $440 million in 45 minutes and briefly caused turmoil in over 100 stocks, the New York Stock Exchange issued three changes to trading rules, not including the new system for executing the buy and sell orders of individual investors, which was launched on the same day, August 1st, and had been approved just a month before.

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In all, the NYSE has made 35 separate changes to the way that stocks are bought and sold on the exchange this year, causing trading firms to update their systems and procedures in order to comply. Most are minor changes. But some, like the so-called Retail Liquidity Platform, or RLP, which was launched the morning of Knight's problems, can be significant. That pace of alterations is down slightly from 2011 in which 73 changes were made, but it's way up from a decade or so ago.

And that's just the NYSE. Rival Nasdaq has already made 93 changes to its trading rules this year. Not to mention the dozens of changes that come from upstart exchanges like Kansas City-based BATS, and other trading networks where more and more stock transactions happen.

Knight has said that its trading flub was the result of its own programming error, which caused the company's computers to erroneously execute millions of buy and sell orders in nearly 150 stocks, and not the fault of the NYSE. Market experts, though, say at least some of the blame rests with the NYSE and the Securities and Exchange Commission, which has allowed the exchanges to dramatically increase the number of changes they adopt a year.

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"Many of the changes are inane paperwork exercises that waste taxpayer dollars as well as industry resources," says James Angel, a Georgetown University finance professor who is an expert in the structure and regulation of financial markets. "The SEC has plenty of lawyers, when what they need are market plumbers."

Angel and others say all the rule changes are making it hard for even sophisticated trading firms to keep up, leading to problems like Knight's huge losses, 2010's so-called Flash Crash and other incidents, which collectively appear to have sapped some investor confidence in the market.

And while it appears the rules governing electronic trading are changing constantly, the SEC has done little to update its rules that make sure those changes go smoothly. Back in 2004, the Government Accountability Office, after an audit, recommended that the SEC institute guidelines that would strengthen procedures firms have to go through before upgrading or implementing new computer trading software. Nonetheless, the SEC has yet to update its so-called Automation Review Policies, which were put in place more than two decades ago in response to the 1987 stock market crash.

It's not clear how much the changes at the NYSE contributed to Knight's problem trades. Although they happened on the same day as the launch of the NYSE's new RLP system, Knight's rivals do not appear to have had similar problems. Knight appears to have timed its ill-fated software update to coincide with the launch of the NYSE's RLP, which is meant to grab back some of the trading volume the exchange has lost to Knight and others.

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Some observers say the NYSE appears to have shortened the time it takes to implement changes as well. RLP, for instance, was only approved by the SEC in early July. Angel says another problem was that RLP was rolled out all at once. He said exchanges typically start new trading platforms with a few test stocks, before make it available for all.

Worse, a number of observers question the need for RLP in the first place, other than to boost business for the exchange. NYSE says it will lead to better prices for individual investors. But many observers say those so-called "price improvements" will be miniscule - in many instances less than a penny per share.

Knight declined to comment. Officials at the NYSE say while RLP was approved just a month ago, the exchange made the details of the system public back in October. What's more, a number of firms, including Knight, successfully tested the system earlier this year. And while the system was available for trading in all stocks, NYSE officials said they instructed firms to only use the system for a few specific stocks initially.

Rule changes have slowed somewhat recently. The high water mark for the NYSE was in 2008. That year the exchange instituted or announced 143 changes to the way stocks are traded or priced on the NYSE. Still, even the current pace is way up from a decade or so ago, when it was more common for the exchange to issue around 30 rules a year.

"Rule filings have grown expansively in the past few years," says Christopher Nagy, who is head of KOR Trading, which advises firms on their trading systems. "It used to be five rules a month. Now it's five a day. We need to slow down the changes to give people time to test."

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