Investors Should Pay Close Attention To The Knight Capital Debacle

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Even though the major banks are under intense scrutiny, they still rely quite heavily on trading activities to make money. And as JPMorgan’s “London whale” and a string of other banks have demonstrated, they have a tough time keeping tabs on the amount of risk they are taking. In many cases, a single set of mistakes was felt by the entire bank – and in some instances the entire banking community – and it is clear that many risk factors involved are often completely overlooked, misunderstood or that banks are unable to manage them.

The recent “technology breakdown” at Knight Capital (NYSE:KCG) extends the paradigm of things that can go really bad, really quickly for financial firms in terms of their technology and trading. After all, it is not very hard to conceive a situation where a rogue trader (as in the case of UBS (NYSE:UBS) last year), a poorly thought through hedging strategy (as in the case of JPMorgan Chase (NYSE:JPM) this May) or a glitch in the systems of a stock exchange (with UBS unfortunately being on the receiving end yet again, this time during the Facebook (NASDAQ:FB) IPO) actually brings the bank to its knees.

What Just Happened To Knight Capital?

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The simplest answer to this question, is that they were very unlucky to have switched to a new software in which a small bug has now led the country’s largest equities trader to the verge of bankruptcy.

Knight Capital put its new software to the job on the 1st of August, and within minutes the company had recorded thousands of erroneous trades with the NYSE. [1] Although Knight Capital promptly pulled the plug on the software as soon as the error was detected, it had already committed itself to trades worth billions of dollars by then, which it was forced to close out. The result – it ended up with an immediate pre-tax loss of $440 million.

And on the 2nd of August, the very next day after the debacle, the company found itself looking for a buyer. Its shares sank from around $10.30 at the beginning of Wednesday to $2.50 by the end of Thursday.

There Are Lessons To Be Learned

On closer examination, the reason Knight Capital is almost down under as well as the reason for the huge one-time losses some of the banks have reported in the recent past turns out to be the same – risk management. Or rather a lack of it. Financial firms have been pushing technology, the economy and their people to extract the smallest value that is on offer in the extremely competitive global financial market. But clearly, their risk management systems have failed to keep up.

The result is what appears to be a rather large number of unwarranted losses on the income statements of financial firms that often threaten to take down the entire business model. After all, UBS’s estimated loss of $350 million from the Facebook IPO glitch is not far from the $440 million Knight Frank lost to the software bug. The bank was obviously affected to a much smaller extent because of its significantly bigger asset base – and not to forget its much more diversified model.

But unless banks invest more time and effort in better identifying the risks that they are running into each time they enter a trade and in the scramble of profits they sacrifice proper testing and risk management procedures, there is always a chance that the one mistake could put an entire business at risk.

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Notes:
  1. Knight Capital Group Provides Update Regarding August 1st Disruption To Routing In NYSE-listed Securities, Knight Capital Press Release, Aug 2 2012 []