How to Prevent Market Mayhem Like the Knight Fiasco

Judging from the screaming press coverage, the Knight Capital Group incident is already being seen as a devastating blow to an industry that hardly needed one following the global financial crisis, the Eurozone mess, the so-called Flash Crash and Facebook's disastrous market debut.

In a nutshell, it's another high-profile embarrassment that adds more fuel to a widespread perception of today's marketplace as being simply too fast and too complex for regulators or participants to control. It also gives the average investor even more reason to feel disenfranchised.

"I don't know if it's the last straw, but it's certainly another nail in the coffin," said Matt Samelson, the principal of research and consulting firm Woodbine Associates.

Already Pimco founder Bill Gross is speculating as to whether this will mark the death of equities as we know them , while Advanced Trading previously reported that algorithmically-driven episodes like these just might be a simple fact of life in the modern markets.

The nation's regulators understand what's at stake here, which is why authorities from the Securities and Exchange Commission and the Financial Industry Regulatory Authority are already racing to get to the bottom of what caused that technology glitch at Knight, and how it managed to set off a chain of events that will continue to reverberate in the weeks and months to come.

Nevertheless, more regulations are not the answer. The buck stops here with the industry, and it's incumbent on participants to enact a set of best practices to prevent dislocations like these from ever happening. For starters, the updated guidelines released earlier this year by FIX Protocol Limited are a good place to start. Although those are merely recommendations and not enforceable rules, they'd stop errant "buy" programs from cramming what were supposed to be days' worth of orders into five or 10 minutes, which is what one head trader told Advanced Trading happened with Knight Capital.

"How can an algorithm go wild," Progress Software founder and Chief Technology Officer John Bates asked. "Was it back-tested properly? Was there some kind of error in the installation or was there no logic analysis used in the algorithm? The real-time checking has got to improve and I think it would be good to see some industry best practices building on things like (the) FIX guidelines."

Meanwhile Samelson says the exchanges should get tougher about making sure members test their algorithms more effectively.

"Exchanges are self-regulatory organizations which means they have the ability to regulate their members under the oversight of the SEC," he said. "They should be fining their members for disruptive and inappropriate activity. People tend to listen to monetary penalties because it hits them where it hurts – in the pocket."

As for regulations, if anything, the investment community can take heart in the fact that yesterday's events had the potential to spiral into a repeat of what occurred on May 6, 2010, but didn't thanks to a combination of circuit breakers and human intervention.