Bats Says System Errors Cause Pricing Problems

Bats Global Markets Inc., the third-largest U.S. stock exchange operator, said its computers allowed trades that violated rules intended to ensure all investors get the best prices for equities over a period of four years.

Machines 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 in a notice published on its website yesterday. Customers lost $420,360, because of rule violations, Randy Williams, a Bats spokesman, said by e-mail.

The issue allowed technical infringement of rules in the U.S., where trading is fragmented across 13 exchanges and dozens of other venues, aimed at preserving fairness. While losses to any single user would have been close to undetectable and the vast majority of Bats trades executed correctly, the disclosure comes after a year in which breakdowns on American exchanges sowed concern the nation’s electronic equity infrastructure is too complex to manage.

SEC Scrutiny

“Once again, we see there’s a problem with electronic systems, this time an exchange system,” Larry Harris, a finance and business economics professor at the University of Southern California in Los Angeles and former chief economist at the U.S. Securities and Exchange Commission, said in a phone interview. “Bats will get a lot of scrutiny from the SEC at a time when nobody wants that kind of attention. That said, it’s important to recognize that Bats itself identified the problem and brought it to public attention and to the attention of regulators.”

SEC spokesman John Nester declined to comment in an email.

Bats’s computers inadvertently permitted trades counter to specific rules. One regulation involves the best nationally available bid and offer, a central concept aimed at ensuring that even as exchanges proliferate, investors who want to buy and sell shares can be confident they are getting the best prices.

The short-sale circuit breaker, implemented in 2011, was intended to prevent investors from driving down share prices when a stock had already fallen 10 percent from the previous day’s closing level. The curb limits the price of short sales relative to the national best bid.


Bats said some mistakes occurred with so-called price-sliding orders that re-price trade requests based on the movement of the national best bid or offer, under specific circumstances involving other orders. Additional infractions took place when orders pegged or tied to the national best bid or offer traded through that level or executed at a price not permitted under the short-sale rule because of the actions of unrelated other orders.

The trades at inferior prices, called trade-throughs because they trade through or ignore the best available bid or offer, happened 433,000 times, an average of 410 a day from October 2008 to January 2013 on the main Bats stock exchange, the company said. Almost 8,000 similar incidents occurred on the second Bats stock exchange and 617 on its options market, the firm said. Short-selling violations involved more than 3,600 incidents across its equity venues, Bats said.

Bats said it identified the trading issues in an internal review and that none of its customers had reported it. The first indication of the problem was on Jan. 4 and it was confirmed on Jan. 7, according to a statement from the company.

Regulatory Tools

“It’s a miniscule amount of trades but I don’t think the regulators have the tools to keep up with the technology that’s out there and the sheer number of quotes and trades going on,” Joseph Saluzzi, partner and co-head of equity trading at Themis Trading LLC in Chatham, New Jersey, said in a phone interview. “Is this happening at other exchanges? Can I trust regulators to find out? I don’t know.”

The software problem at Bats is a symptom of overly complex market regulations that should be simplified, Chief Executive Officer Joseph Ratterman said in a phone interview. About 250 customers, mainly market-making firms, and 0.004 percent of trades on Bats’s two equity exchanges were affected by the problem that dates back to 2008, Ratterman said. About 0.0009 percent of options trades were affected, he said.

Self Regulatory

The Bats announcement comes amid a securities industry debate about benefits afforded to exchanges in their role as self-regulatory organizations. According to its rules, Bats’s aggregate liability to its customers is limited to $500,000 per calendar month when the exchange makes a mistake in the normal course of business.

Participants may only seek compensation “for losses resulting directly from the malfunction of the exchange’s physical equipment, devices and/or programming or the negligent acts or omissions of its employees,” according to a statement from the company’s website.

“We will explore with the SEC the extent to which we can provide compensation retroactively regarding this issue,” Williams said by e-mail.

The pricing issues at Bats follow the company’s withdrawal of its own initial public offering after a technology glitch in March and the Nasdaq Stock Market’s botched IPO of Facebook Inc. in May, events that undercut investor confidence that exchanges are in command of their technology systems.

Better Trading

Bats, whose name stands for Better Alternative Trading System, rose to prominence in tandem with the proliferation of electronic firms that now dominate the buying and selling of equities in the U.S. The six-year-old equity exchange canceled its IPO on March 23 after errors on its own computer systems kept its stock from trading.

Nasdaq 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 market operator 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.

Nasdaq OMX plans to reimburse its members up to $62 million for losses related to the Facebook IPO, the New York-based company said July 20. The cap on Nasdaq Stock Market’s liability stemming from specific technology errors and malfunctions it causes is $3 million, according to the exchange’s rules, and the higher payout is voluntary. Exchanges have immunity from losses related to activity they undertake as part of their duties as SEC-registered self-regulatory organizations.

Legislation that created the SEC in 1934 also deemed the main venues self-regulatory organizations that oversee their member firms and trading. Critics say the Facebook mishap shows how changes in the structure of markets have made old regulations obsolete.

“Bats is a self-regulatory organization and they’re the first line of defense,” said Saluzzi of Themis. “But it’s for the SEC to come in and say maybe some of these order types shouldn’t be approved because the market is too complex.”

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