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

Comments...

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?

• Prof. Jayanth R. Varma wrote on Tue, 27 Oct 2009 19:35

  Re: Re: SEC formalizes bail out of fat fingers
  

  There are two issues here:

  1. Is the solution fair, just, practical for the specific wrong trade that is being addressed?

  2. How does the solution impact incentives for all parties going forward.

  You are right, academics tend to worry a lot more about the second (long term consequences) while practitioners tend to focus on the first (short term impact).

  I think, exchanges and regulators should pay more attention to the second issue (incentives and long term consequences). If wrong trades are not canceled, traders would have incentives to create better controls on fat fingers.

  As for the exchange taking losses, well they too should have the right incentives to (a) inspect and discipline their members, (b) build better software (the TSE software at the time of Mizuho was atrocious) and (c) take fat finger risk into account in their broker risk management systems.

  • Gaurik Shah wrote on Wed, 28 Oct 2009 11:23

    Re: Re: Re: SEC formalizes bail out of fat fingers
    

    I think sir there is third issue which has to be adressed here as well which you missed out that of immediate systematic chaos in case of bankruptcy of a firm(as a fallout of error trade by one of the firms employee). As i pointed out earlier this errors are considered norm in the industry and cant be wished away, but the worry is of a big errors which threaten to have system wide fallout. And including some error margin will increase the cost of transaction...

    • Prof. Jayanth R. Varma wrote on Wed, 28 Oct 2009 11:44

      Re: Re: Re: Re: SEC formalizes bail out of fat fingers
      

      You are absolutely right. If the fat finger is employed by a Too Big To Fail (TBTF) firm, and makes a sufficiently large mistake, then the entire machinery for dealing with TBTF will be invoked.

      Again, the short run impact favours a bailout of the TBTF, but the long term moral hazard and incentive argument would say that the TBTF should be allowed to fail or at least severe loses should be imposed on its managers, shareholders and possibly on its creditors (in that order).

      Canceling the trade bails out the firm without even appearing to bail it out and so the TBTF and its managers get away too lightly.

      • Gaurik Shah wrote on Wed, 28 Oct 2009 20:24

        SEC formalizes bail out of fat fingers
        

        agreed, canceling the trade is not a good idea... may be one of the solution could be having a insurance against such trades by exchange/clearing corporation. Another good idea which is currently applicable in india is limiting the trades to margin made available by firm. Also i think by cancellin the trade exchange not only bail out TBTF firm it also saves itself from the loss...