High Frequency Traders Love a Good Flash Crash

"If you strike me down, I shall become more powerful than you could possibly imagine." Obi Wan Kenobi.

NEW YORK ( TheStreet) -- Following yet another electronic stock trading blowup -- this time at Knight Capital ( KCG) -- investors may expect a withdrawal from computerized and opaque high frequency trading markets.

Think again. They are just getting started.

Although Knight Capital's shares are off nearly 33% in Wednesday trading and the Securities and Exchange Commission says that it is looking into the "technical issue" that caused the latest Flash Crash, past blowups signal that high frequency trading will continue its unremitting stranglehold over stock markets.

The trading glitch at Knight Capital -- which executed $19.5 billion of stock trades in June and is a big high frequency trading conduit to the public markets -- led to unusual reading in 148 stocks listed on the New York Stock Exchange at the open. The yet to be explained electronic trading failure mirrors many past blowups.

In March, high frequency exchange BATS Global Market failed miserably at conducting an initial public offering of its shares on its own exchange, pulling the listing after its shares opened at 3.8 cents instead of an IPO pricing of $16.

The IPO debacle was a black eye for BATS Global Markets, which hasn't refilled IPO papers and stripped its chief executive Joseph Ratterman of his chairmanship. Technical errors on BATS' high frequency exchange not only condemned its IPO, glitches also caused wild fluctuations in dozens of stocks including Apple ( AAPL).

During and after the high frequency trading melee, the Securities and Exchange Commission tried to reassure investors that it was keeping a close eye on the March trading error and that action would follow if warranted. "As is our practice, SEC staff has been and will continue to be in discussions with BATS to determine the cause and extent of the incident and steps BATS is taking to remedy the situation," said SEC spokesman John Nester, at the time.

Although the March IPO dud cast serious doubt on BATS' ability to trade its shares or the hundreds that pass through its exchange daily, no public insights, inquiries, or regulations have been disclosed to investors by the SEC in the subsequent four months.

A call to an SEC spokesperson today confirmed that the regulator hasn't yet offered any policy recommendation related to the BATS blowup.

Instead, the SEC offered this statement on Knight Capital's Wednesday's trading issues: "As is our practice, we are closely monitoring the situation and in continuous contact with the NYSE and other market participants."

Sound familiar?

Meanwhile, in the intervening time since BATS' IPO debacle, trading on its exchanges have surged to new records. In May, the company reported its fourth best month on record for U.S. equities market share, with 11.7% of stock market trading. That U.S. equities market share rose to 11.5% in June, also up from year-ago levels.

BATS IPO debacle emboldened the high frequency trading exchange - it seems - instead of pulling equity traders from the glitch-prone electronic trading system. Such is the world of stocks since a May 2010 flash crash - precipitated by high frequency exchanges -- which caused some of the largest market swings in U.S. history.

The original May 2010 flash crash caused U.S. stocks to tumble, pushing down the benchmark Dow Jones Industrial Average by about 1,000 points, or about 9%. Stocks recovered shortly afterward.

With this context in mind, investors should expect little out of the SEC and continued equity trading market share gains for high frequency traders, as true investors retreat from stock markets.

The SEC instead will likely emphasize 'circuit breakers,' which can minimize the impact of trading blowups, without addressing the larger problem of system-wide issues with high frequency trading. In June, the SEC approved a rule to provide new safe guards for wild and unexplained swings in the trading of U.S. stocks - however the new procedures will be implemented on a one-year 'pilot' basis starting in February - little consolation for those who may have unnecessarily lost money on Wednesday.

At Wednesday's market open, Knight Capital said that its market making operations were impacted by technical errors, causing problems in the routing of nearly 150 stocks to the New York Stock Exchange. That routing error appears to have caused a wild market open and the halting of trading in Corelogic ( CLGX), China Cord Blood ( CO), Kronos Worldwide ( KRO), Trinity Industries ( AAPL) and Molycorp ( MCP).

In addition, the stocks of Goodyear Tire & Rubber ( GT), Manitowoc ( MTW) and Pandora Media ( P) surged over 10% at the open, while Level Three Communications ( LVLT) fell 15%, on the irregularity.

The wild swings are thought to result from a flood of computer-generated high-frequency trades, which flooded the market. Trading on some of the biggest companies -- including Radio Shack ( RSH), and Dole Foods ( DOLE) -- were also affected.

The New York Stock Exchange said it would cancel stock trades that in six companies that reflected moves in excess of 30% between the market open and 10:15 a.m. Those stocks include Wizzard Software Corporation ( WZE), China Cord Blood ( CO), China Cord Blood, E-House (China) Holdings ( EH), American Reprographics ( ARC) and Quicksilver Resources ( KWK).

"An initial review by Knight indicates that a technology issue occurred in the company's market-making unit related to the routing of shares of approximately 150 stocks to the NYSE," said Knight, in an emailed statement obtained by Bloomberg. "Knight notified its market-making clients this morning to route listed orders away," according to the statement.

All things told, while Knight Capital shares - which were also hit from losses stemming from Facebook's ( FB) botched IPO - may take time to recover, don't expect any significant regulatory action or market changes from Wednesday's trading problems.

" You may get some blue-ribbon panel to put out a report in five months, but nothing will get done," said Joseph Saluzzi, a co-founder and co-head of equity trading at Themis Trading, in an earlier interview with TheStreet.

-- Written by Antoine Gara in New York

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