Saturday, April 5, 2014

"Knightmare" on Wall Street (2012)

Knight Capital on Wall Street

Knight Capital was one of the US's biggest trading firms. Its primary business was selling and buying stocks for its clients. “Knight uses complex computer algorithms to trade swiftly in and out of stocks while retail brokerages rely on the company to execute billions of dollars of trades a year for small retail customers” (Strasburg). On August 1st, 2012 Knight's computer system sent out a wave of more than four million stock orders. They were testing out a new program that was not supposed to trade anything in the public. This resulted in a tremendous loss for the company of $460 million, which almost sent the firm into bankruptcy and their stock price slid by 63%. Most of the trades were made within a 45 minute time period, and amounted to about $10 million a minute.

This error affected many different stakeholders, and could have been potentially a lot worse. The stake holders in this case includes Knight Capital as a company, all of its employees, all of its clients and the stock market as a whole including all trading firms, and independent investors. The company called this a computer error, and put the blame entirely on the software malfunction. The Securities and Exchange Commission (SEC) had something else to say about blame for this incident, but Knight Capital still refuses that theyo did anything wrong. They SEC launched an investigation to determine were the company went wrong. There results were that the company “violated trading rules by failing to put adequate safeguards in place to prevent the barrage of erroneous stock orders” (Stevenson). They charged Knight Capital a $12 million fine. The SEC found that the error was in the computer system, but blamed the incident on human error. They said that Knight failed to keep necessary safeguards and controls to prevent something like this from happening. There were also several alerts sent out to employees that could have acted as warnings that morning but were ignored. “Knight Capital’s violations put both the firm and the markets at risk,” Andrew Ceresney, co-director of the SEC’s Division of Enforcement said in an article (Philips). The result of humans not putting in the right protection methods and ignoring warnings costed the company huge losses. The company had to have other companies invest in it to help save it. It eventually merged with Getco to form what it is now known as, KCG Holdings. This is what the problem comes down to; the human error had a huge impact on the company, and the stakeholders. This question to be answered is, were the actions of the employees before the error happened ethical? To judge if the actions were ethical or not, four key theories of ethics must be used.
The chart shows the loss of profit that Knight Capital
experience throughout the day on August 1, 2012
IndividualismThe first theory to be used is Friedman’s Economic Theory, also known as Individualism and was founded by famous economist Milton Friedman. Individualism states that everyone has the right to pursue their own interests, but people do not have the right to stand in the way of others pursing their own interests. This theory also applies to business and corporate social responsibility. "The only goal of business is to profit, so the only obligation that the business person has is to maximize profit for the owner or the shareholder's" (Salazar). Under Individualism, a business is solely concerned about profit maximization to benefit the shareholders, and not of the business' obligations to society at large. When applying this to Knight Capital’s case the fact that the company had tremendous losses must be looked at. The company experienced losses so large that it almost went into bankruptcy without other companies bailing it out. It ultimately was faced with a merger because the company was having difficulties surviving. This is the complete opposite of profit maximization. The stock price fell by 63%, so they didn’t maximize the price for shareholders either. Under the individualism approach the action by Knight Capital employees would not be considered ethical because they did not effectively maximize profit or shareholder wealth.

The next of the four theories is utilitarianism. Utilitarianism ethics often refers to doing the greatest amount of good for the greatest amount of people, and can be defined as “an ethical tradition that directs us to make decisions based on the overall consequences of our acts" (DesJardens 24). This means that decisions are said to be ethical if the result benefits the majority of people involved. When applying the theory of utilitarianism to the Knight Capital case, the stakeholders involved must be examined. The first of the stakeholders is the company Knight Capital itself. They were affected negatively because of the huge losses and fines that they suffered from. The next set of stakeholders includes the firm’s employees. These employees were affected because they were forced to work long hours trying to resolve the problem, and some even slept in the office overnight (Strasburg). The employees also do not benefit when the company is doing poorly, because that often leads to pay cuts and job losses. The clients did not benefit from this situation. A lot of them were afraid they were going to lose their entire investment so they switched firms. They had no faith in the company. The stock market as a whole was affected by the error because it falsified the stock prices. It made the value of Knight Capital’s stock decrease drastically, but it also affected the prices of the accidental stocks. Investors of Knight Capital lost money, and it had an overall bad effect on the market. So, since none of the stakeholders benefited the actions did not do the most amounts of good for the most amounts of people. In fact, it did no good for anybody, so the actions can be ruled unethical under utilitarianism.

Kenneth Pasternak, founder of Knight Capital

The third theory to be applied is the Kantian approach, which is essentially the opposite to Utilitarianism. The Kantian approach "emphasizes acting with respect toward all autonomous beings" (Salazar). This means that all people must be treated with equal respect, no matter what. A person following the Kantian approach would but individuals before the consequences of their actions, which is why it is the opposite of Utilitarianism. The Kantian approach also focuses on the formula of humanity, which expresses the need to not use people as a means. It is somewhat difficult to apply the Kantian theory to this case. The employees chose to ignore the alerts that something may go wrong, and by doing so they did not show respect to the stakeholders in this case. They had the knowledge that if something like what happened occurred there would be huge losses. They knew it could potentially crash the stock market because of the volume of the firm. If that had happened millions of people would be affected. So, they did not treat all people with respect when they chose to ignore the alert emails that morning. Management also did not show respect to all people when they chose to not have adequate protection against this happening. Knight Capital’s actions are unethical under the Kantian approach. 

Virtue TheoryThe last theory to be used is virtue theory. Virtue theory is based off of Aristotle’s ethics and says that for something to be good it must perform its function well. It also says that people must perform rationality to function well, which will in turn make them happy. To apply the virtue theory four key virtues must be examined. The first question to be asked is, did the company show honesty? No, the company did not show honesty because they are still denying that there was any blame to be put on humans. They say it was all because of a computer malfunction, which is not the case. The next virtue is courage. The company did show courage, but immediately trying to fix the problem. They had their employees stay over night working. The next virtue is temperance, or reasonable desires. They did not display temperance in their actions. By not setting up the proper protection it shows that they were not wiling to think beyond what was supposed to go right. They did not desire things to go wrong, but also did nothing to prevent it. The company does not display the last virtue, which is justice. They do not show justice because when they got into the mess they were unable to bail themselves out and had to heavily rely on outside investors. They should have been able to fix their own mess, or file bankruptcy instead of dragging other companies into it. So, reflecting back on the virtues it can be said that Knight Capital’s actions were not ethical.


DesJardins, Joseph R. "Ethical Theory and Business." An Introduction to Business Ethics. 5th ed. New York, NY: McGraw-Hill/ Irwin, 2014. 23-37. Print.

Philips, Matthew. "The SEC's Knight Capital Fine Adds Insult to Injury." Bloomberg Business Week. Bloomberg, 17 Oct. 2013. Web. 01 Apr. 2014.

Salazar, Heather. Business Ethics, Economics, and Individualism. Powerpoint Slides
Salazar, Heather. “Kantian Business Ethics,” in Business in Ethical Focus, ed. Fritz

Allhoff and Anand J. Vaidya (Broadview Press, 2008).
Stevenson, Alexandra. "Knight Capital to Pay $12 Million Fine on Trading

Violations." DealBook Knight Capital to Pay 12 Million Fine on Trading Violations Comments. N.p., 16 Oct. 2013. Web. 01 Apr. 2014.

Strasburg, Jenny, and Jacob Bunge. "Loss Swamps Trading Firm --- Knight Capital

Searches for Partner as Tab for Computer Glitch Hits $440 Million." Wall Street Journal, Eastern edition ed. Aug 03 2012. ProQuest. Web. 1 Apr. 2014 .

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