A little over a month ago, an unnamed trader placed a market order to buy 1,000 shares of an unnamed stock, even though just a few hundred shares were on offer. The order was executed simultaneously on all American exchanges, and the price jumped precipitously.
It wasn’t, technically speaking, an "obvious error" in the sense that he didn’t accidentally sell one million shares instead of 100,000; he didn’t push ‘buy’ instead of ‘sell’; and he didn’t buy 1,000 shares at the price of $1 instead of one share at the price of $1,000. Furthermore, his 1,000-lot order didn’t cause a major market move like the May 6 flash crash, which sent the Dow down more than 900 points in a matter of minutes, only to see it bounce right back.
Even though it didn’t fit the definition of an "obvious error," the incident was clearly a mistake, and at least one exchange we spoke to made it go away.
Speaking generically on handling similar types of problems, Ed Boyle, who just left NYSE Euronext to handle business strategy development at Getco, says, "We would call all the traders who made the other side of those trades and say, ‘look, a customer put this order in improperly. He shouldn’t have done that, and he knows he shouldn’t have done that. We would like to adjust the price appropriately. Can we give him a break?’"
Market makers usually will adjust the trade, even though they don’t have to.
"They will do it as an accommodation," Boyle says. "It shows how the industry and traders work very closely with the trading desks at each exchange and internally to make sure certain customers get fair trade within the industry."
Such procedures echo the out-trades of old, when floor clerks would gather at long tables to rectify, negotiate and settle discrepancies and errors from the previous day. The main difference is that errors today, though less frequent, have greater consequences.
Indeed, as markets become more interlinked and trades more instantaneous, the damage that an error can inflict is increasing. Nothing illustrates this better than the flash crash, which — contrary to initial reports — wasn’t a classic "fat finger" trade where someone pushes a wrong button. Rather, it was a case of someone hitting the market with an unusually large trade at the exact wrong moment, according to "Findings Regarding the Market Events of May 6, 2010." Issued jointly by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) in late September, the report concluded that the market was already on the ropes when a massive sale of S&P E-Mini futures contracts triggered a flurry of additional sales by high-frequency algorithmic traders.
Since then, the SEC beefed up its circuit breaker system, which already imposed trading halts across all markets when prices move too far too fast.
The flash crash, however, only moved a small part of the market a far distance, and fast. It didn’t move enough of the market to trigger circuit breakers, so the SEC piloted circuit breakers that halt trading in shares that move more than 10% in five minutes. It also added provisions for busting trades that happen outside the circuit-breaker range.
All of these provisions are designed to prevent wild moves that are sparked by something other than real-world events, while also letting the market go where it should if real-world events so dictate.
The new circuit breakers have been triggered several times since June, and as we go to press, the SEC is working with exchanges to develop a plan that it’s calling "limit up/limit down," which could either be more complex and sophisticated than the current system, or simpler, depending on which arguments win out.
Critics have attacked the SEC for taking so long to come up with a solution, but anyone who attended the November Futures Industry Association’s (FIA) Expo in Chicago can tell you the issue isn’t as easy as it seems. Four separate panel discussions focused on the new risks ushered in by electronic trading, and they offer a glimpse into the challenge of keeping a market running right and preventing it from driving into a ditch.
The FIA has issued two reports on market risk. The first, "FIA Market Access Risk Management Recommendations," was published in April by the Principal Traders Group (PTG) — just before the flash crash. Then, in November, the PTG followed up with "Recommendations for Risk Controls for Trading Firms" (see "Nipping it in the bud").
Both reports are available online and suggest requiring exchanges and brokers to impose pre-trade filtering on customers. The recommendations apply mostly to traders entering trades manually, and include such things as position limits, price collars and volatility filters, but also call for the development of more algorithms that can protect markets from machines engaged in high-frequency trading.
The CFTC technology advisory group also commissioned a survey to see which brokers already implement such measures, and got responses from 20 exchanges globally. The report has not yet been released, but preliminary figures made public show that 16 of the 20 exchanges have some sort of controls, and 12 have filters for fat-finger errors. Beyond these, however, there is wide variance in what exchanges do and don’t do.
"About seven of the exchanges have some sort of maximum long-short position limits in place," said Leslie Sutphen, formerly head of eSolutions at Newedge, who helped put the survey together. "Some of the exchanges require a margin utilization figure to be in place, and three of the exchanges have some requirement for some kind of intraday profit and loss restrictions as well."
Such mechanisms are not new, but traders have pushed back against their use in the past because they can slow down transaction time — even if for a nanosecond. Sutphen, however, says she’s never experienced that sort of resistance.
"The trading firms we deal with always had no problem if we required them to have risk controls in place," she says. "The challenge we face is that they’re not standardized across firms, so if you’re going to implement mandatory risk controls, not necessarily mandated by the exchange, you’re going to end up with 600 different risk management tools that you’re supposed to be maintaining. It’s very difficult for an FCM to perform that task."
Indeed, several people have called for the implementation of standardized best practices — including CME Group Executive Chairman Terry Duffy.
He’d like to see the whole industry adopt the CME’s stop logic functionality, which under certain stressful market conditions temporarily pauses the markets for five to 20 seconds. When testifying before lawmakers investigating the flash crash, he said stop logic paused the market long enough to let more liquidity in, and that trading on the CME led the bounce back.