Prevention better than the cure for US equity markets

Despite suggestions that flexibility on trade cancellations would have eased losses suffered Knight Capital following its 1 August glitch, the complexities involved mean it is unlikely to be resolved at a forthcoming regulatory roundtable.

Despite suggestions that flexibility on trade cancellations would have eased losses suffered Knight Capital following its 1 August glitch, the complexities involved mean it is unlikely to be resolved at a forthcoming regulatory roundtable.

While a number of industry observers have said some flexibility in busting trades would have eased the US$440 million loss suffered by Knight – thereby removing the need for the market maker to seek last-ditch refinancing – others point out the potential complexities that could arise. The topic is likely to be raised at a round table on market technology scheduled by the Securities and Exchange Commission for 14 September in Washington DC.

“Any discretion on the cancellation of orders would raise debates on fairness, so regulators do need to be as specific as possible,” said Howard Tai, senior analyst, Aite Group. “There may be a legitimate resting order that just happens to interact with an erroneous order, or a significant event like M&A activity, or a surprising earnings estimate announcement that triggers a price swing in the stock in question. These types of incidents make it tricky to apply flexible cancellation rules at times."

Under the rules adopted by the SEC shortly after the 6 May 2010 flash crash, trades in stocks priced US$25 or less are broken if the last price is at least 10% away from the circuit breaker trigger price. Stocks priced between US$25 and US$50 will be considered erroneous if they deviate by 5% from the circuit breaker trigger price and stocks over US$50 will be broken if they move 3% away from the circuit breaker trigger price.

In recent months, both Nasdaq OMX and NYSE Euronext have been required to cancel erroneous trades based on these rules.

On 1 August, a flaw in the market making system used by Knight Capital sent mistaken orders in around 148 stocks. However, only six of the stocks qualified as erroneous under the SEC rules, leaving Knight with substantial losses. On 22 August, the erroneous trading rules again kicked in after a number of trades in Nasdaq-listed Peet’s Tea and Coffee were cancelled when the share price jumped by almost 5% in a matter of seconds.

“If you apply discretion to the cancellation of trades, the question is where to draw the line,” said Miranda Mizen, director of equity research at TABB Group. “Would it be based on size, the fact that we don't want anyone to fail, the size of losses? These parameters would be very hard to determine and agree upon.”

Up for debate 

How to deal with trading system errors will be one of the core topics at the SEC round table. While the regulator has not said whether the discussion will lead to new regulations, it said the discussion has been arranged in light of the growing influence and risks posed by technology in today’s market structure.

A panel will discuss the benefits of using independent filters, objective test and other real-time processes to detect, limit and potential terminate erroneous market activity with the aim of limiting their impact. Another panel will look at error prevention and consider best practices and practical constraints for creating, deploying and operating systems that generate and route orders, match trades, confirm transactions and disseminate data.

According to Mizen, the primary focus from the SEC should be on having controls in place to prevent errors occurring in the first place.

Miranda Mizen, Tabb Group“More needs to be done to avoid errors from those responsible for order flow. Brokers need to be accountable for clients and exchanges need to ramp up their monitoring processes,” she said.

One of the questions raised following the Knight incident was whether the firm had adequate pre-trade risk controls in place that would have stopped erroneous orders from hitting the market. A rule banning unfiltered access to markets was implemented by the SEC on 14 July 2011.

Mizen added that the pace of regulatory change since the flash crash – a watershed moment for the equities market that intensified the attention on electronic trading – has been too slow.

She points in particular to the circuit breakers used to briefly halt trading in the event of a price swing. Single-stock circuit breakers were implemented at the same time as the erroneous trade rules but market participants quickly called for a change in the methodology used. The SEC finally approved a proposal to move to a limit up/limit down system in June, for implementation on a pilot basis from February next year.

“The regulation to provide the rules that protect the market need to be accelerated,” she said. “ Putting something in over a year later is less than satisfactory.”