Knight Capital Is Just Another Example Of Poor Risk Management 9/7/23, 11:40 PM

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Knight Capital Is Just Another

Example Of Poor Risk
Management
Trefis Team Contributor
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Great Speculations Contributor Group

Aug 3, 2012, 06:13pm EDT

This article is more than 10 years old.

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Knight Capital Is Just Another Example Of Poor Risk Management 9/7/23, 11:40 PM

Even though the major banks and trading firms 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, these institutions have a tough time keeping tabs on the
amount of risk they are taking amid increasingly complex and fast market.

In many cases, a single set of mistakes was felt by the entire bank – and in
a few instances the entire banking community – making 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 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 last year),
a poorly thought through hedging strategy (as in the case of JPMorgan
Chase 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 IPO) actually brings the bank to its knees.

What Happened To Knight Capital?

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

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Knight Capital Is Just Another Example Of Poor Risk Management 9/7/23, 11:40 PM

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. It
now has reportedly found a line of credit.

There Are Lessons To Be Learned

On closer examination, the reason Knight Capital has almost gone bust 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 – a rush for profits at
the expense of risk management. Financial firms have been pushing
technology, their balance sheets 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 run each time they trade, roll out new technology platforms or
place the utmost importance on near term profits at the expense of proper

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Knight Capital Is Just Another Example Of Poor Risk Management 9/7/23, 11:40 PM

testing and risk management procedures, there is always a chance that

seemingly small mistakes could put the entire house at risk.

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