In Celebration of a Failure


Last month, our Foolish investigative team turned its attention to the trading meltdown that happened at Knight Capital (NYS: KCG) . Not only did we dig into exactly what went down at Knight on August 1 when its trading systems went haywire, but we also examined associated market-technology issues and how investors can best navigate today's markets.

However, looking back at all of the coverage of Knight Capital, I noticed something conspicuously missing from the story: victims. In an interview with CNBC not long after the meltdown, Knight's CEO Tom Joyce made it clear that preventing this problem from impacting clients was an immediate and primary concern. In his words: "[Knight's] suffering immunized clients against any issues."

I heard something very similar when I spoke with Stifel Financial (NYS: SF) CEO Ron Kruszewski, whose company also deals with retail clients. He told me that Stifel didn't have any customer orders that needed to be cancelled or investors calling because they'd lost money due to Knight. In fact, I heard this same refrain over and over again. Our team of researchers tried to find investors that lost money because of the Knight glitch. We couldn't find any. They may still be out there, but if they are, they're few and far between.

In a broader sense though, Manoj Narang of the high-frequency trading firm Tradeworx may have summed up the situation best in a conversation I had with him:

[Knight] paid for it, their shareholders paid for it. The government and policy makers should not be involved in preventing firms from self-destructing. There's no bailout required here. If firms screw up they should be allowed to fail.

Compare that outcome to NasdaqOMX's (NAS: NDAQ) computer problems on the day of the Facebook (NAS: FB) IPO, when millions were lost by investors and trading firms, including $35 million lost by Knight. Compare it to the collapse of MF Global (OTC: MFGLQ) which saw more than a billion dollars in supposedly protected customer money inexplicably vanish. Or compare it to the 2008 financial meltdown where the actions at a handful of major financial institutions nearly brought down the entire U.S. financial system.

In the coverage of Knight's trading glitch, what the media got right was that there was a failure at Knight. What it got terribly wrong, though, was making the assumption that failure is an inherently bad thing. With progress comes failure. With risk comes failure. Unless we want to extinguish our country's ability to grow and innovate, it's absolutely wrong-headed to assume that we should live in a failure-free environment. What we need instead is an environment where effective failure can occur. That is, failure that punishes those that failed and not everyone else around them.

Knight was an effective failure. The company made a mistake, and that mistake cost it $440 million and nearly its future. Some of that was due to the way Knight is run and Tom Joyce's insistence that customers be protected from the fallout. Some of it was a result of new regulations put in place following the Flash Crash, including stock circuit breakers and clear rules on breaking erroneous trades. And some of it was just plain old luck.

Sure, the circumstances of Knight's trading glitch need to be studied to figure out why there was such a massive failure. However, in an era where failure -- particularly in the financial industry -- seems all too often to punish everyone but those who actually failed, Knight's trading glitch should also be studied for how it failed so well.

About that other failure...
It's hard to even know where to start when it comes to the fiasco that was Facebook's IPO. But for investors looking at that stock today, the question isn't as much what happened, but what will happen. With the stock at half the price of its first day on the markets, is it now a good investment? Motley Fool tech analyst Evan Niu has dug in to bring you that answer. To see what he has to say about Facebook, click here and download Evan's special report on Facebook.

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