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SEC Said to Probe Role of Canceled Orders in Crash

SEC Chairman Mary Schapiro
Mary Schapiro, chairman of the U.S. Securities and Exchange Commission, testifies at a House Financial Services subcommittee hearing in Washington, D.C. Photographer: Brendan Hoffman/Bloomberg

The U.S. Securities and Exchange Commission is examining whether high-speed traders helped destabilize equity markets during the May 6 crash by repeatedly placing and canceling orders in an attempt to manipulate share prices, a person with direct knowledge of the inquiry said.

The strategy is among several practices being investigated by regulators, said the person, who declined to be identified because the probe isn’t public. The SEC is also looking into whether traders may have used a technique known as sub-penny quotations to artificially generate price movements, the person said. The inquiry was first reported by the Wall Street Journal.

Nanex LLC, a Winnetka, Illinois-based market-data provider, has presented regulators with data it says shows some traders may be trying to manipulate the market by overwhelming exchanges with information, slowing data feeds and creating trading opportunities. Andrei Kirilenko, a senior financial economist at the Commodity Futures Trading Commission, said July 14 his agency is taking Nanex’s research “very, very seriously.”

“It’s a concern for not only exchanges but for most trading firms themselves because at the end of the day it could overwhelm the various platforms that form our market structure,” said Sang Lee, co-founder and managing partner at research firm Aite Group LLC in Boston. Users of market data “want to make sure what they’re seeing is the true market, not something that’s artificially created,” he added.

Under Pressure

The SEC and CFTC are under pressure from lawmakers to show they have a grip on markets increasingly dominated by electronic trading. The SEC has mandated circuit breakers to curb stock volatility and is undertaking a “comprehensive review” of the May 6 sell-off that temporarily erased $862 billion from the value of U.S. equities in less than 20 minutes, Chairman Mary Schapiro said that month.

“A lot of systems at exchanges and brokers got bogged down with a lot of information” on May 6, slowing data feeds used by investors to place buy and sell orders, said Eric Hunsader, Nanex’s founder. His company provides market data to brokers, hedge funds and individuals.

Quotation volume on May 6 reached a record 1.1 billion messages, according to data from Jordan & Jordan, a New York- based provider of data services. Trading volume on U.S. stock exchanges that day was 19.3 billion shares, the highest since Oct. 10, 2008, according to data compiled by Bloomberg.

‘Just Noise’

Some firms may have deliberately caused delays in market data feeds to try to profit from the misinformation provided to other investors, Hunsader said. “A lot of the quote data was what we call quote stuffing, which was just noise,” he said. “They were orders with no intention of being executed because they were so far out of the market.”

Nanex provided data it had compiled about May 6 to “a room full of our enforcement, surveillance and economist staff, and staff from the Securities and Exchange Commission,” Kirilenko said July 14. He added that regulators were supplementing data from Nanex with information about the identities of trading firms. The July 8 meeting took place at the CFTC. A second meeting with the SEC occurred on July 19, Hunsader said.

SEC spokesman John Heine declined to comment.


“My understanding of Nanex’s allegation is that quote stuffing is not so much about putting orders in and pulling them back and trying to make the market go to a certain place,” said Jamie Selway, a managing director at broker Investment Technology Group Inc. in New York. “It’s more about an attempt to position yourself and then destroy the market by rendering it unusable with message traffic.”

He added: “Maybe it’s above my pay grade, but I struggle to see how it would be that beneficial to someone to blow up an exchange.”

Richard Gorelick, chief executive officer and co-founder of RGM Advisors LLC, an automated trading firm in Austin, said in an interview in New York that evidence of high cancellation rates “isn’t crop circles or Stonehenge.” He said that while his company doesn’t engage in quote stuffing, explanations may exist for why some firms submit large numbers of orders over the course of a couple seconds. If the intention was to manipulate markets, the firms should be prosecuted, he said.

Quotations in about half the companies traded on the New York Stock Exchange slowed down during the afternoon of May 6, according to Hunsader. “It looked like NYSE had the biggest problems” with data delays among exchanges, especially for the 30 stocks in the Dow Jones Industrial Average, he said. NYSE Euronext spokesman Ray Pellecchia declined to comment.

A Through L

NYSE’s quotes sent to the consolidated quotation system for most companies whose names start with A through L -- except I and J -- “experienced delays of more than 20 seconds” on May 6, Hunsader said. The consolidated quotation system provides vendors such as Bloomberg LP, the parent of Bloomberg News, and Thomson Reuters Corp. with data about the best-priced bids and offers in NYSE-listed stocks across venues.

As a result of the delays, NYSE’s bid in some stocks was higher than the offers to sell shares on other venues, resulting in what’s called a crossed market, Hunsader said.

“That’s a problem because it’s misinformation and causes a number of firms to shut down, so you lose liquidity,” he said. “It instilled more fear” in a market that was already volatile, he said.

A joint report by the SEC and CFTC on May 18 found that some firms reined in the liquidity they provided the markets on the afternoon of May 6. An updated account of the regulators’ findings about the plunge is scheduled for release this month.

Computer Overload

Exchanges, brokers and trading firms face the problem of computer overload caused by high volumes of quote data in a fast-paced electronic market, said Aite’s Lee. It’s important to ensure that firms aren’t engaged in a “widespread practice to intentionally cause problems” through cancelations, he said.

Some options exchanges charge firms when their ratio of cancelations to trades exceed a certain level. The computer capacity required to process options data is higher than what’s needed for equities. Stock markets don’t charge users for high rates of canceled trades.

“The fact that you essentially can consume exchange capacity for free -- that’s going to lead to some behavior that’s not all that useful,” Selway said. Policing cancelation rates is difficult, he added. “The reality is some cancels are done for good risk reasons and others are not,” he said.

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