The Financial Times reports that “The Tokyo Stock Exchange is considering replacing its trading system, even though it is merely a year old, following computer problems that have shattered the exchange's reputation and damaged Tokyo's status as a financial centre.”
Clearly the Mizuho trading error that I blogged about last month has been the main driving force behind this move. I would argue that open source is the better way to go if the goal is to make the trading system more robust.
I have been reading the official explanation that the Tokyo Stock Exchange (TSE) put out on the Mizuho incident. As I understand it the sequence of events was as follows.
- At the beginning of the first day of listing of J-COM (December 8, 2005), a special bid quote of 672,000 yen was being displayed in order to determine the initial listing price. Special quotes are used at the TSE during the call auction (Itayose method) that is used to determine the initial listing price of stocks that have never been traded before at the TSE or at any other exchange. The Guide to TSE Trading Methodologygives the details of this process.
- At 9:27 am while this special quote was being displayed, Mizuho mistakenly placed a sell order for 610,000 shares of J-COM at 1 yen, instead of the intended 1 share at 610,000 yen.
- The Mizuho order allowed the conditions for execution of the special bid quote to be fulfilled and the trade was completed. The call auction (Itayose method) requires that all market orders as well as all orders on one of the two sides of the order book should be executed and that the volume executed should be a minimum of 1000 trading units. The Mizuho order was large enough to meet all these conditions.
- This trade established the inital listing price of 672,000 yen as also the lower price limit for the day of 572,000 yen. The Tokyo Stock Exchange has computed that in the absence of the Mizuho order, a price of 912,000 yen per share would have prevailed.
- The remaining part of the Mizuho order was now deemed to be an order at the lower limit price of 572,000 yen (“deemed processing”) and started executing against various buy orders.
- “Meanwhile, Mizuho Sec. made several attempts to cancel the order, but as these cancel orders were made while executions were being processed, an irregularity occurred in which the target order was not canceled. This is an irregularity that arises when deemed processing is applied to an order, and a corresponding opposing order exists.”
Summing up the nature of the problem, the Tokyo Stock Exchange states:
“This is an incident that occurs when an issue is newly listed on the TSE directly and, as in this case, while a special bid quote is displayed, such a large amount of orders is placed that the net amount exceeds the number of the special quote order, and many sell orders still remain after the initial price is determined, to which deemed processing is then applied and then orders are placed at that price. As such, we are committed to strengthening supervision of newly listed issues in the near future and conduct extensive, detailed investigations of our system while considering the possibility of this and all other cases in the future, in ensuring irregularities such as this do not occur again. Also, the TSE will conduct a prompt, thorough analysis of the details of the cause of this recent irregularity in cooperation with the trading system developer, Fujitsu, Ltd.”
It appears that the irregularity that was observed would have occured only under very special circumstances that may never be repeated in future. It is also evident that in a complex trading system, the number of eventualities to be considered while testing the trading software is quite large. It is very likely that even a reasonable testing effort might not detect all bugs in the system.
Given the large externalities involved in bugs in such core systems, a better approach is needed. The open source model provides such an alternative. By exposing the source code to a large number of people, the chances of discovering any bugs increase significantly. Since there are many software developers building software that interacts with the exchange software, there would be a large developer community with the skill, incentive and knowledge required to analyse the trading software and verify its integrity. In my view, regulators and self regulatory organizations have not yet understood the full power of the open source methodology in furthering the key regulatory goals of market integrity.
Also, there is a case for simplifying the trading system. The trading system at TSE is unnecessarily complex because of the existence of price limits and the complex combination of call auction (Itayose method) and continuous auction (Zaraba method). TSE needs to question the very need for special quotes.