08/09/2012 10:18 am ET Updated Oct 09, 2012

Knight Falls Down in Its Heraldic Duties

Knight Capital will not be invited to join the Order of the Garter anytime soon. Ironically named after the knights of the medieval era who fought for the general welfare of all, Knight let loose a computer program on Aug. 1 that was far from chivalrous. It cost the market maker $440 million, nearly toppled the firm, and posed a threat to the general welfare of all investors.

Times have changed since days of old when knights were bold (and computers did what they were told). Today's super-fast algorithms and high speed electronic trading systems rule global market autobahns while the stewards (regulators) are still riding horses.

Since the May 6, 2010 flash crash there have been thousands of mini-crashes and many dozens of market-threatening computer glitches. Knight Capital was not the only culprit in August; a glitch on the Tokyo Stock Exchange Group's trading system halted derivatives trading for about 95 minutes (its second major system error in seven months). And trading in Spanish equities was disrupted for more than four hours when a technical glitch hit the systems of Bolsas y Mercados Españoles SA.

Not very encouraging is it? As Advanced Trading said: "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."

As Adam Sussman, partner and director of research at Tabb Group, said to Securities Technology Monitor: "In this instance, it is not the pigs that get slaughtered... but the lambs.''

Pity the lambs -- the investors. They want to believe that the markets are safe. They want to leap in and out without being eaten by wolves. They want to think that machines are biddable and programs run smoothly. But with traders and market makers creating and deploying new systems and algorithms constantly, the danger of something going wrong is inevitable.

Aite Group reckons the average algo only lasts for three months before it loses its edge and has to be replaced with something snazzier. Then once in the marketplace, algos can move so quickly that by the time a human has noticed an error, the damage is likely to already have been done. So what can be done to stop the Knights of this world from throwing dodgy electronic lances into the marketplace?

Back-testing, testing in a non-production environment, applying logic analysis to the algorithm will help to prevent problems in the first place. Then real-time monitoring of the algorithm is necessary to see if it is performing correctly; you need algorithms to monitor trading algorithms. As I said to Advanced Trading, I think it would be good to see some industry best practices building on things like the FIX guidelines.

The Knight algo glitch may have been prevented entirely had the firm been utilizing adequate controls like real-time surveillance and risk monitoring. We can only hope that this incident serves as a reminder of how seemingly minor technical glitches can cause drastic market moves, and that more trading firms and exchanges deploy technology to focus on control and safety -- not just speed. Then, instead of being kicked out of Camelot for jeopardizing the general welfare of all, they can be knights in shining armor to the markets.