Knight Capital (NYSE: KCG), the biggest ETF market maker in the US and a major player in European ETF and share trading, is struggling to survive after incurring an estimated US$440 million pre-tax trading loss on Wednesday. The loss was caused after an algorithm-based stock order apparently went badly wrong, causing multiple trades in about 150 stocks to be executed at the opening of New York trading on Wednesday in minutes instead of days.

The company's stock plunged 33 percent on Wednesday during US trading hours. On Thursday the stock dropped a further 63% amidst rumours that trading counterparties had stopped dealing with the firm and that possible bidders for the business had declined to put forward a rescue plan.

After the close of New York trading on Thursday a journalist at Fox Business, Charlie Gasparino, reported that Knight's chief executive, Thomas Joyce, is now considering a Chapter 11 bankruptcy filing that would aim to reorganise the firm through a complicated transaction known as a "363" spinoff. Under such a reorganisation, it's unclear how much, if any residual value would be left for Knight's share- or bondholders.

When reporting its second quarter results on July 18, the broker/dealer said that it had US$365 million in cash and cash equivalents on its balance sheet at the end of June, less than the reported loss incurred on Wednesday.

Knight's explanation for what went wrong is so far limited.  "A technology issue occurred in the company’s market-making unit related to the routing of shares of approximately 150 stocks to the New York Stock Exchange (NYSE)," the company said in a prepared statement on Wednesday.

According to Fox Business news' Gasparino, citing an unnamed source, the trading malfunction involved Knight Capital buying US$5 billion of stock in a trade that was intended to take place over five weeks but was ultimately executed in just 20 minutes.

For its part, the NYSE said on Wednesday that it was reviewing trades on 148 stocks for possible cancellation under its “clearly erroneous” rules. The NYSE later ruled that trades on six of those stocks were cancelled:

• Wizard Software Corp. (NYSE: WZZ), on trades at or above $4.68 a share
• China Cord Blood Corp. (NYSE: CO), at or above $3.22
• Reaves Utility Income Fund (NYSE: UTG), at or below $0.0497
• E-House (China) Holdings Ltd. (ADR) (NYSE: EJ), at or below $3.36
• American Repographics Co. (NYSE: ARC), at or above $5.71
• Quicksilver Resources Inc. (NYSE: KWK), at or above $5.91

The NYSE said the trades occurred between 9:30 a.m. and 10:15 a.m. Eastern time on Wednesday, and noted that its review decisions are final and aren’t subject to appeal.

Exchange-traded funds which suffered abnormally large price movements and trading volumes during the first hour of trading on Wednesday included Vanguard's Utilities ETF (NYSEArca: VPU), Market Vectors' Gold Mining ETF (NYSEArca: GDX) and Direxion's Gold Miners Bull 3* ETF (NYSEArca: NUGT). It's unclear whether these ETFs were affected directly by the errant algorithm at Knight, or indirectly via heavy trading in the funds' constituents, which then triggered automatic trading in the funds.

According to Dr. Christopher Clack, director of the financial computing MSc programme at University College, London, the latest high-frequency trading mishap is symptomatic of broader structural problems in the financial markets. In particular, says Clack, algorithm-based trading programmes can pushed very easily into a destructive loop, generating orders to buy and sell at increasingly divergent prices.

"An otherwise provably stable high-frequency trading algorithm can be panicked into issuing market orders," says Clack. "And we now know the precise conditions needed to induce a round-robin panic amongst several high-frequency traders, in a so-called 'hot potato' event."

Wednesday's trading loss is the second bad mishap in less than three months for Knight. In May the firm suffered a US$35 million hit during Facebook's initial public offering. In that case, Knight is attempting to recover losses from the Nasdaq OMX stock exchange, which the trading firm blames for bungling the IPO. This week's loss, however, now threatens to end the firm's 17-year existence as an independent entity.

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