Bats Highlights Hazards as Flows to Funds Hit Record

Bats Global Markets Inc.’s disclosure that computer errors that permitted almost 450,000 bad trades comes just as investors start to regain confidence in stock markets.

The announcement that the Lenexa, Kansas-based stock exchange had mishandled orders since 2008 marked the fourth breakdown by one of America’s biggest bourses or trading firms in the past year. The mishap underscores why investors withdrew $375 billion from equity mutual funds since the financial crisis began in 2007, according to data compiled by research firm EPFR Global.

Individuals have just started to change behavior. A record $3.1 billion flowed into U.S. stock funds in the first week of

2013. Customers won’t keep sending money unless regulators fix the structure of markets that led to malfunctions last year from Facebook Inc.’s initial public offering to the near-collapse of Knight Capital Group Inc., according to Walter Todd, who oversees about $940 million as chief investment officer of Greenwood Capital Associates LLC in Greenwood, South Carolina.

“From a sentiment standpoint, it gives people another reason to think the markets aren’t working,” Todd said in a telephone interview on Jan. 10. “Our markets are based on confidence, our business is based on confidence, so I think this is detrimental.”

Equity Exchanges

Machines that match orders for two Bats equity exchanges and an options venue allowed trades to occur at prices inferior to the best available bid or offer and enabled others to violate rules for short sales, or bearish bets, the company said in a notice to clients on Jan. 9. Customers lost $420,360 because of the rule violations, according to Bats.

Bats’s error hasn’t affected its relationship with customers, Randy Williams, a spokesman for the company, wrote in a Jan. 11 e-mail. Its share of U.S. equity trading has averaged

12.2 percent in the previous two days, compared with 11.9 percent in the first six days of this month.

Exchange operators have called for an overhaul of rules that boosted high-speed trading and the fragmented equity markets. Trading that was dominated by three main markets in the 1990s has been broken up among 13 stock exchanges and about 50 private broker-run dark pools where institutions can trade anonymously. The SEC is investigating Bats and officials are concerned about similar order types at other exchanges, a person familiar with the situation said Jan. 10.

Interlocking Computers

The errors don’t suggest the industry is incapable of overseeing itself, said Joseph Ratterman, Bats chief executive officer. Instead, regulations that have been established to oversee the thousands of interlocking computers that make up the American equity market are too complex, he said in a Jan. 10 interview.

“You could do away with a significant amount of complexity by simplifying some of the regulatory guidelines,” Ratterman said. “If the regulatory environment were to simplify, then the functionality customers demand to reflect their trading interest would simplify as well.”

Advocates of today’s markets dismiss suggestions that infrastructure breakdowns prompt individuals to avoid equities. Investors are adding cash to mutual funds as valuations remain below their historical average and reports show the economy is gaining momentum, according to John Carey, who helps oversee about $200 billion at Pioneer Investments in Boston.

“People are coming back to equities probably because of more fundamental interests in stocks and the market and a news event like that I don’t think would throw them off track and discourage them from investing,” Carey said in a phone interview on Jan. 11.

Equity Flows

About $3.1 billion flowed into U.S. equity funds during the week ended Jan. 9, according to EPFR Global. That’s the most since the Cambridge, Massachusetts-based research firm began tracking the industry in 2000. The Standard & Poor’s 500 Index reached a five-year high last week as companies reported better-than-estimated earnings.

Analysts predict profits for companies in the S&P 500 will rise 8.6 percent this year to a record $110.40 a share, according to data compiled by Bloomberg. The U.S. equity gauge trades at 14.8 times reported earnings, about 9.8 percent below the six-decade average of 16.4, the data show.

The mutual fund flows mark a turnaround for investors. About $69.1 billion was withdrawn from funds that invest in American stocks in 2012, according to data from EPFR.

Haywire Trading

Bats’s mistake followed other examples of computerized trading errors that hurt investor confidence. An equity rout temporarily sent the Dow Jones Industrial Average down almost 1,000 points on May 6, 2010, causing investors to question the stability of market mechanics and the effectiveness of regulators.

The Dow average fell as much as 9.2 percent that day, most of it between 2:30 p.m. and 3 p.m., after aggressive selling of so-called E-mini S&P 500 futures by a mutual fund company caused a flight of liquidity. As equity market makers and other providers of bids and offers withdrew, trades in individual stocks took place at prices including fractions of 1 cent and $99,999.99.

Nasdaq Stock Market mishandled Facebook’s IPO on May 18 when an auction to set the first traded price for the shares failed. The exchange’s systems were overwhelmed by order updates and cancellations before the stock began trading, causing the exchange to make technology changes that prevented confirmations of orders and trades from being disseminated for hours, and leading to confusion among investors, brokers and market makers.

Bats IPO

Bats canceled its IPO in March after the company couldn’t get its stock to start trading on its own exchange. Knight almost went out of business in August after it bombarded U.S. equity exchanges with erroneous orders in the wake of improperly installed software that malfunctioned.

Share volume for companies listed on U.S. stock exchanges has declined to an average 6.2 billion shares a day since the Facebook IPO, 17 percent less than the previous 12 months, data compiled by Bloomberg show. Investors withdrew $202.7 billion from equity mutual funds since the May 2010 flash crash, according to EPFR data.

“With lots of complexity, the concern I have is that people won’t trust the markets,” Barry James, who helps oversee $3.5 billion as president of James Investment Research in Xenia, Ohio, said in an interview at Bloomberg’s headquarters in New York. “I think that already exists. It’s why people have been taking money out of the markets.”

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