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. This blog is currently suspended.

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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     View/Post Comments (5)     permanent link