Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Thu, 08 Oct 2009

SEC formalizes bail out of fat fingers

Exchanges world wide have often bailed out fat fingered traders who punch in wrong buy or sell orders. I have blogged about this here, and also about a rare contrary example here and here. Such bail outs create a moral hazard problem because traders have insufficient incentives to install internal controls and processes to prevent erroneous orders.

Instead of stopping this practice, the SEC has now stepped in to formalize the moral hazard and has also set exceptionally low thresholds for such bail outs:

In general, the new rules allow an exchange to consider breaking a trade only if the price exceeds the consolidated last sale price by more than a specified percentage amount: 10% for stocks priced under $25; 5% for stocks priced between $25 and $50; and 3% for stocks priced over $50.

I believe this move by the SEC reflects regulatory capture: those who are harmed by trade cancellation are typically day traders and other small traders who have little voice in the regulatory system, while those benefited by the bail out tend to be large trading firms. (The very term day trading is always used pejoratively – when a large firm does it, the terminology changes to high frequency trading which suddenly sounds a lot more respectable).

Three years ago, I wrote: “Clearly exchanges can not be trusted with the discretion that is vested in them. The rule should be very simple. Traders should bear the responsibility (and the losses) of their erroneous trades.” I wonder now whether the regulators can be trusted with the discretion that is vested in them.

Posted at 09:37 on Thu, 08 Oct 2009     5 comments     permanent link


Gaurik Shah wrote on Tue, 27 Oct 2009 19:18

Re: SEC formalizes bail out of fat fingers

I think this is where there will be difference between a academic and practitioner, without any disrespect to you, I think once you should see the way and lack of technology in equity dealing rooms in india, in current scenario error trades are inevitable and considered part and partial of the game... but in some of the case like the one in Tulip IT on which you blogged i must say that although solution arrived at was probably the most absurd and exchange coudnt have done worse but probably all the solution available wouldnt have been less absurd except for one wherein exchange do not cancel in which case following would have happened: 1) Broker who entered the order would declare bankruptcy 2) Then exchange would have to act as counterparty and would take the loss on its books and if error trade was as big as in case of Mizhuo then probably exchange itself would be in serious trouble 3) there would be widespread chaos but that would be a just solution all other solution would be unjust to some party. Do you have any solution in mind which would be practical as well as just to all the parties involved and not break down the system?