A malfunction on the Market Maker Automated Quote Management System (MMAQMS) introduced by Nasdaq as a consequence of the flash crash has left the US exchange operator paying approximately US$3 million in compensation to market makers.
On 25 April, a glitch caused MMAQMS to use “invalid and stale market data” to execute trades in 85 securities. Nasdaq acknowledged that a system malfunction had resulted in automated quotes being posted at “aberrant prices” for around half an hour, starting 09.28, but said steps had been taken to prevent a recurrence. “In many of these cases these quotes resulted in executions for participants,” according to a statement by the exchange.
Trades executed in the affected securities that were over 30% away from the benchmark price were subsequently broken by US exchanges. Approximately US$3 million has been paid by Nasdaq to an unspecified number of market makers to reimburse them for trades made on their behalf through MMAQMS. The average number of markets makers for any given Nasdaq security is around 15.
Responsible party
On 28 April the Nasdaq filed with the US regulator, the Securities and Exchange Commission (SEC), to increase its liability for claims related to a systems malfunction or error of the Nasdaq Market Center up to US$3 million from US$500,000 in a single calendar month.
The filing says that claims must relate to functions that are “system enforced” by the Nasdaq trading system on behalf of the claimant, such as locked/crossed markets, trade through protection, market maker quoting, order protection, or firm quote compliance.
Under the terms, Nasdaq is responsible for determining that the malfunction or error was caused exclusively by Nasdaq's trading system and that no outside factors contributed to the malfunction or error.
MMAQMS was introduced on 6 December 2010 to automatically generate quotes in compliance with new SEC rules in the absence of quotes entered by the market makers themselves.
“Nasdaq can insert orders on behalf of its market makers if they have not yet entered their own quotes,” said Owain Self, UBS's global head of algorithmic trading. “The exchange specifically inserted the incorrect quotes which resulted in the trades that lost the market makers money.”
Rule changes made on 6 December 2010, as part of the SEC's response to the flash crash of 6 May 2010, oblige market makers to place quotes on an exchange not more than 8% away from the national best bid offer (NBBO) price or, for the market open and close periods, where the new circuit breakers are not operable, such as before 09.45, not more than 20% away from the NBBO.
Previously, a market maker was able to enter stub quotes, far away from the NBBO, to nominally comply with its obligation to maintain a two-sided quotation when it did not wish to actively provide liquidity. By quoting at an extreme price a stub quote was never likely to be executed upon.
During the flash crash, which saw the value of the Dow Jones Industrial Average fall by 1,000 points in a 20-minute period before recovering, the use of stub quotes, which could be as low as a cent, was seen to exacerbate the race to the bottom. By preventing market makers from quoting so far from the NBBO, regulators hope to limit sudden stock movements.
Compensation culture
Although technical errors have become increasingly common at stock exchanges in recent years, compensation is extremely rare. Following an outage at the London Stock Exchange (LSE) on 25 February 2011, UK broker Evolution declared its intention to pursue reimbursement for lost business, but no official claim was lodged. One of the challenges to successful claims is the difficulty of calculating and apportioning responsibility for losses. Even though European bourses such as the LSE now face much stiffer competition since MiFID, US exchanges are even more sensitive to losses in market share.
“Exchanges in the US do have to be more competitive than in Europe because liquidity is extremely portable,” said Self. “If problems occur they need to be resolved quickly and customers assured that they won't recur. Europe doesn’t have competition to that degree yet.”