Bats Blaming Market Rules as Calls of Overhaul Grow
Bats Global Markets Inc., the stock exchange operator that acknowledged four years of trading errors, blamed the mistakes on regulations it says are too complex.
The rule violations at Bats, which canceled its initial public offering last year after its own computer systems kept the stock from trading, threaten to further erode confidence in U.S. stock exchanges. Operators including NYSE Euronext (NYX) have called for an overhaul of regulations that boosted high-speed trading and the fragmentation of equity markets to 13 stock exchanges and about 50 private broker-run dark pools from three dominant venues in the 1990s.
“The challenge facing a lot of the exchange providers is that the market structure in America has become far too complex,” Thomas Caldwell, who oversees about $1 billion as chairman and chief executive officer of Toronto-based Caldwell Securities Ltd., said in a phone interview. “It’s very easy in the complex market structure for minor errors to occur and not be detected because of the multiplicity of the exchanges that the SEC has created.”
The order types that produced the error at Bats are used to comply with regulations the U.S. Securities and Exchange Commission implemented in 2007 to ensure all investors get the best prices for equities, Chief Executive Officer Joseph Ratterman said in a phone interview yesterday. Simpler rules would limit such technical mishaps, he said. The Lenexa, Kansas- based company intends to reimburse clients for the $420,360 lost because of its errors since 2008.
The SEC is investigating the rule violations and government officials are concerned about similar order types at other exchanges, according to a person familiar with the situation. Still, Bats’s errors are probably specific to the company’s trading processes, said the person who asked not to be named because the matter is confidential.
“We routinely review these matters with the exchanges as part of our oversight,” John Nester, an SEC spokesman, said in an e-mail yesterday. Ratterman declined to comment on a potential regulatory response.
Exchanges shouldn’t rely on regulators to catch errors and need to be more vigilant about checking and testing their systems, said Thomas Garcia, head of equity trading at Santa Fe, New Mexico-based Thornburg Investment Management Inc. The mishaps at Bats raise concern about the possibility of other software breakdowns in the industry, he said.
“The exchanges and these guys that are trading at really high speeds, they need to make sure their systems are good before they start,” Garcia said by telephone. His firm oversees more than $80 billion. “It falls on the exchanges. The regulators are there to help regulate and facilitate that sort of thing. They can only look at so many trades.”
The errors don’t suggest the industry is incapable of overseeing itself, Ratterman said. Among the approximately 250 members affected by the breakdown, five firms lost more than $10,000 and 74 lost less than $100, Stacie Fleming, a spokeswoman for Bats, wrote in an e-mail.
Inspection of operating systems is an ongoing practice, said Rich Adamonis, an NYSE Euronext spokesman. Jim Gorman, a spokesman for Jersey City, New Jersey-based exchange operator Direct Edge Holdings LLC, declined to comment on the status of its computer systems. Rob Madden, a spokesman for Nasdaq OMX Group Inc. (NDAQ), also declined to comment.
Executives at NYSE Euronext and Nasdaq OMX, the owners of the largest U.S. equity exchanges, called for a regulatory review last year. Joseph Mecane, head of U.S. equities at NYSE Euronext, said in September that the increase in venues, advances in technology and the use of increasingly complex orders warrant a coordinated assessment. Eric Noll, executive vice president and head of transaction services at Nasdaq OMX, told a U.S. Senate subcommittee last month that more testing and more coordination are needed.
Increased competition has improved technology and benefited investors, Direct Edge Chief Executive Officer William O’Brien said in June.
Bats’s error involved software written to handle the myriad order types that exchanges provide to automated-trading clients. The orders offer ways for them to optimize executions amid split-second price changes and within the strictures imposed by regulators. Among other responsibilities, venues must seek to prevent trades at prices inferior to the best levels available anywhere in the country.
Operators must prevent other violations, including a phenomenon known as a locked market, when a bid on one venue is the same price as the ask on another, rather than separated by a spread. Normally, a stock will be available for sale at a level a penny or more than the bid price. The maintenance of the gap, codified in rules adopted in the last decade as venues multiplied, has traditionally been viewed by regulators as a way to facilitate orderly trading.
Bats offers its users order types with price-sliding features designed to adjust to changes in the best national bid and offer while preventing markets from locking. The trades that shouldn’t have been permitted involved this type of order, Ratterman said. The company has no plans to eliminate the orders, which are often used by brokers and professionals to get the executions they seek, he said.
“The price-sliding is predominantly a reaction to the prohibition on locked markets,” Ratterman said. “It creates complexity in everybody’s systems. We’ve been advocating for some time we need an industry review of some elements” of Regulation NMS that govern locked markets, he said.
The violations also occurred in situations that programmers describe as a “race condition,” in which computers are communicating with each other in real time while adjusting to new information in the market. Computers that match orders for two Bats equity exchanges and an options venue allowed some 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.
“We will most likely see more of these types of errors before investors’ disdain produces a government push to overhaul the marketplace,” Larry Peruzzi, senior equity trader at Cabrera Capital Markets LLC in Boston, wrote in an e-mail. “Maybe the old methods and dealing with people wasn’t so bad after all.”
Bats discovered the problem that involved almost 450,000 transactions on Jan. 4 through data inspections by its operations department looking for anomalies in transactions and how the exchange handles orders, Ratterman said. It informed the SEC and member firms on Jan. 9, he said.
Bats was founded by a high-frequency trader in 2005 after the SEC approved rules that spurred competition with the then- dominant New York Stock Exchange. The company, whose acronym stands for Better Alternative Trading System, became an exchange in 2008.
Venues run by Bats execute about 12 percent of American share volume, compared with about 10 percent at the end 0f 2010, data compiled by Bloomberg show. Customers of the all-electronic exchange company range from retail brokers and securities firms to professional traders and institutional investors.
“My concern would be not really with Bats’s own reputation as a result of this, but the potential negative impact on the electronic market overall,” Sang Lee, managing partner at Aite Group LLC in Boston, said in an e-mail. “If one of the best technically driven exchanges is having issues, what does that say about the potential issues with the rest of the marketplace?”
NYSE Euronext, the biggest U.S. exchange operator, agreed to pay $5 million in September to resolve regulatory claims that the Big Board violated rules by giving certain customers a head start on trading information. The NYSE sent data through two proprietary feeds to paying customers before relaying the information to the so-called consolidated feed, which distributes trade and quote data to the public, the SEC said.
Nasdaq Stock Market mishandled Facebook Inc.’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’s error follows market breakdowns that have weighed on investor confidence. Trading 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 lower than the previous 12 months, data compiled by Bloomberg show. Investors pulled money from mutual funds that invest in American stocks, with $377 billion in outflows since the May 2010 flash crash, according to data from Washington-based Investment Company Institute.
“It highlights why people don’t trust the market,” Rick Fier, director of equity trading at Conifer Securities LLC in New York, said in a phone interview. “Although it was not a very large problem, meaning it didn’t effect that many trades as a percentage, people at home will only hear that the market is not working properly still, and that no one is doing anything to correct it.”
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