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Are Debacles Like the Knight Capital Fiasco Inevitable?

Although FIX Protocol's new risk control guidelines take aim at market dislocations like the one on display Wednesday, Woodbine's Matt Samelson says no form of regulation or oversight can stop them from happening.

The errant trades by embattled market maker Knight Capital on Wednesday cast fresh light on just how easy it is for a fat finger error or a misfiring algorithm to dislocate an entire market.

Details from today's debacle will continue to emerge in the coming days and weeks, but it's already clear that situations like the Knight Capital fiasco are exactly what FIX Protocol Limited (FPL) had in mind when it announced an update in June to risk control guidelines it established last year.

[A Behind the Scenes Look: The Knight Capital Group Trading Floor.]

Numerous media reports say the problem at Knight began as soon as trading opened on Aug. 1, when large orders that were supposed to be filled throughout the session were mistakenly transacted in a much shorter time frame than intended. Speculation also abounds that a fat finger error or rogue algorithm may have been the culprit.

In addition, the Wall Street Journal said the reports of irregular trading have raised fears that trades had been accidentally duplicated by algorithms, rather than being contained to a single server the way they would have been in the past.

Should any of these factors ultimately prove to be the cause of Wednesday's wild trading activity, on the surface at least, it seems that FPL's suggestions for market participants should be an effective remedy to the sorts of problems that can arise in a complex, high-speed marketplace. But Matt Samelson, principal at research and consulting firm Woodbine Associates, says such events represent a new normal and that no form of regulation or oversight can stop them from happening.

"Events like these, while considered unusual, are to be expected in highly automated markets such as those we have today," he wrote in an email to Advanced Trading. "Even in the best testing environment, it is not possible to account for all the factors that might cause an algorithm to act unpredictably." Samelson also suggests it's up to the exchanges to hold their members accountable for actions that can send the markets spiraling out of control.

"Hopefully, a reasonably sized fine will provide the incentive for members to more thoroughly test their algorithms if this is attributable to a broker-dealer algorithm," Samelson wrote.

And if the Knight Capital situation was caused by a broker client algorithm, he says, exchange members should be forced to refine their risk management practices around sponsored access. As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio

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