August 3, 2012

Knight’s Test Algo Went Live Instead of Real Algo

Nanex speculates on the root cause of Knight Capital’s trading collapse - that Knight Capital’s test algo went live instead of real algo.
If true, that would explain a lot.

To simulate real trading, the test algo would generate test cases for the real algo. It would consistently generate mirror-image trades for the real algo.

And, if the test algo accidentally went live against NYSE’s RLP, it would trade leading to losses.

Per Nanex, 
When the time comes to deploy the new market making software, the Tester is accidentally included in the release package and deployed into NYSE's live system. On the morning of August 1st, the Tester is ready to do its job: test market-making software. Except this time it's no longer in the lab, it's running on NYSE's live system. And it's about to test any market making software running, not just Knights. With real orders and real dollars. And it won't tell anyone about it, because that's not its function.
Because the Tester indiscriminately buys at the ask or sells at the bid, and because the bid/ask spreads are very wide during the open, we now understand why many stocks moved violently at that time. The Tester was simply hitting the bid or offer, and the side it hit first determined whether the stock opened sharply up or down.

Since the Tester doesn't think it's dealing with real dollars, it doesn't have to keep track of its net position. It just buys and sells in waves of test patterns. This explains why Knight didn't know right away that it was losing a lot of money. It probably didn't even know the Tester was running! And when they realized they had a problem, the first likely suspect would be the new market making software. We think the two periods of time when there was a sudden drop in trading (9:48 and 9:52) are when they restarted the system. Once it came back, the Tester, being part of the package, fired up too and proceeded to continue with its tests.

Interesting if true.

But, how could a battle-hardened firm such as Knight make such a basic mistake?

Tags: root cause of knight capital failure, why did knight capital algo fail, knight capital test harness, knight capital tester software