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.
"In 2008, we were averaging close to 50 errors in a month and now we’re down [to] around 19 or fewer, and we really do believe that it’s very much so attributable to the automated processes that we put in place: Price banding, no-bust ranges, credit controls," says CME COO Bryan Durkin. "Each year we come up with some additional innovation, which allows us to minmize the occurrence of these situations."
Ed Dasso, manager of market regulation for Intercontinental Exchange (ICE), says ICE is looking into the adoption of stop logic, and also believes in more uniformity across platforms.
"There should be standardization," says Robert Brown, global head of eBusiness integration at BGC, "but it’s going a little bit too far to say they need to be in place for every single trader."
Steffen Kohler, head of product development at Eurex, says procedures are already standardized in the EU.
"In the U.S., you have these case-to-case laws," he says. "But in the EU, the principle is one rule has to fit everything, which is a challenge because different market participants have different interests."
The debate becomes intense when they start talking about what happens if the filters fail and an error takes place — especially if that error triggers other trades in other accounts, and those trades lose money. On particularly wild days, like May 6, trades executed outside a certain range may be "busted" (canceled), and it’s not always clear what guidelines indicate if that happens or not.
"They don’t tell you right away, either," says Shelly Brown, a director with Chicago trading firm PEAK6 Investments. "We spent some long hours on May 6 not knowing what our position was or what our risk exposure was, and we’re not alone."
The problem, he says, is not the busted trades, but the trades that remain after a bust. "If you’re a market-maker or options trader, you’re always hedged. That’s rule number one," he says. "But let’s say you have a position, and then you hedge it, and then the first trade gets busted. Now what you thought was a hedge is really a liability. That’s what we were afraid was going to happen to us on May 6."
Fortunately, that didn’t happen — at least not to him. But trades were busted, and traders say that makes them reluctant to take positions on wild days for fear of either hedging or exiting those trades and then finding themselves back in the market.
The CFTC exchange survey cited above shows that six of the 20 exchanges require those who make an error to compensate those who lose money if that error triggers contingent orders, such as stops.
Boyle says the exchanges prefer to adjust rather than bust, but that that’s not always possible. "Let’s just say this is a stock that opens at $4, but then you get this outlier price, and suddenly it’s at $1," he says. "You can’t always adjust a customer’s buy limits back up to, say, that $4 level because the customer says, ‘No I have a limit in buying it at $1, and I’m not buying them at $4.’"
Kohler agrees. "On the one hand you have market makers that need certainty and immediate certainty would be best," he says. "On the other hand, we have a number of end customers that do not have this highly sophisticated trading validation methodology and infrastructure and we have to give them the chance to get out of a trade if the price is bad."
"We adjust wherever we possibly can in the U.S.," says Lynn Martin, COO of NYSE.Liffe. "Europe is a slightly different set of considerations because the U.S. has more algorithmic traders spread across more market structures."
When busts do occur, she adds, it’s important to keep the lines of communication open and clear.
"On May 6, in the equities market, quite a few trades were busted as a result of their impact on the market," she says. "In a situation like that, the most important thing is to communicate effectively with the market about when a decision is made, how it is being made and why."
Don Wilson, CEO of hedge fund DRW, agrees — and says firms must communicate errors as soon as they discover them as well. In some cases, that’s incentivized.
"At Eurex, if you apply for a mistrade within the first 30 minutes, the trade would be busted," he says. "Then, from minute 31 to minute 180, the beneficiary of the trade has the right to make the decision to either [bust it] or adjust it."
That works in futures, but less so in equities and options where trades are executed at the best price on several exchanges simultaneously and more interlinking positions are created as a result. In those markets, the chance remains for a market-maker to be stuck with unhedged positions in the event of a busted trade. Boyle, however, says that concern shows how far the markets have actually progressed.
"It’s like the automobile," Boyle says. "When it went 10 miles per hour there was little risk of a serious injury in an accident, but that changed once you got it going 50 or 60, and safety standards needed to follow."
He says that markets have gotten faster and more efficient, so both operators and users have to become more diligent.
"Your broker better be very professional in how he’s handling himself and how he’s working," he says. "And the exchanges all need to become very good at monitoring and controlling the process. We’re like the car manufacturer and the brokers are the users."
And using the speed analogy, if the old floor with runners bringing orders into the pit was the 10 mph stage, current markets where trade latency is measured in micro-seconds has broken the sound barrier. Pilots know what happens when you make a mistake at that speed.