How to Save a Wounded Market from Rogue Algos

When an investment firm deploys a new trading algorithm, you can almost hear Russell Crowe's cry from "Gladiator": "At my signal, unleash hell." But instead of slaves overtaking their armor-clad Roman oppressors in a bloody uprising, Knight Capital unleashed another type of unholy mess late this summer. Within the space of an hour, the market maker's new and reportedly untested algorithm went rogue and started making a series of baffling and seemingly unstoppable trades. By the next day, the beaten Knight Capital was looking for suitors to save it from the $400-million damage it created.

With automated trading accounting for as many as three out of every four trades on Wall Street, a crash brought on by a rogue algorithm was perhaps inevitable. Following the Knight Capital disaster, Advanced Trading's October digital issue examines the question that every buy-side trader should be asking: Are broker algorithms a ticking time bomb?

You couldn't ask for a better example of how quickly today's fast markets can claim a victim. Knight Capital was a well-respected firm. The fact that other companies quickly came to its rescue not only shows that the firm is a prized asset (obviously, this was one hell of a business opportunity), it also suggests that the company had a smart team with respected people at the helm. Think back to 2008, when Lehman Brothers collapsed: No one rushed to the barricades to support CEO Dick Fuld in his time of need.

[Who Owns The Risk If A Third-Party Algo Goes Rogue?]

Here at Advanced Trading, we examined the fallout of Knight Capital's rogue algo. Senior editor Justin Grant looks at how the buy side is responding to the market maker's near implosion, while buy-side veterans discuss the question that everyone should be asking: Can you ever trust third-party algos again? If things for a company as bright and risk-averse as Knight Capital can go this badly, who's to say that the next sell-side or broker-dealer algorithm won't go rogue as well?W

It may be fall, but things are heating up in the States, to say the least. The presidential election next month will decide the leader of the proverbial "free world," but perhaps more important, the steward of the nation's economy and the regulator-in-chief of Wall Street. Let's hope we have seen the last of these bloody algorithms unleashed on the already wounded markets.