Options Market Suffers Biggest Disruption Since AprilMichael P. Regan, Nick Taborek and Alex Barinka
When Scott Maidel of Russell Investments answered the phone 20 minutes after the start of U.S. equity trading on Aug. 20, there was a Goldman Sachs Group Inc. employee on the line with a request: stop sending orders for stock options.
Confusion was sweeping trading desks as prices for equity derivatives swung without reason, leading to speculation a computer program had gone haywire at one of the 12 U.S. options exchanges. Contracts traded for $26 one minute and $1 the next.
The representative on the phone explained what was happening: Goldman Sachs was having a technology issue that prevented it from handling orders for listed contracts. While Maidel, who helps oversee more than $237 billion as a money manager at Russell Investments, was grateful for the swift explanation, Wall Street’s latest computer error angered professionals from California to London who didn’t know whether their transactions would be voided by exchanges.
“I traded with someone and seven hours later I still wasn’t 100 percent sure that the trade was good,” said Daniel Brady, president of San Francisco-based Entropy Capital LLC, a proprietary, event-driven trading firm. “It’s unfair to the counterparty. They don’t know exactly what their position is until several hours later in the day. What are they going to do?”
NYSE Euronext’s Amex Options said less than two hours after the malfunction that “as permitted by the rules, we anticipate that most of the impacted trades will be busted.” Goldman Sachs, which generated $5.8 billion in revenue from equities last year, said in an e-mail that any potential losses would be within the firm’s risk limits and not material to its finances. Goldman Sachs shares rose 0.9 percent to $158.48 at 10:10 a.m. in New York after sliding 1.5 percent yesterday.
The breakdown is one of a growing number of trading failures that have coincided with the expanding complexity of global financial markets. U.S. equity trading, which began with one group of men under a buttonwood tree on Wall Street more than two centuries ago, has become dispersed among more than 50 computerized platforms accessible around the world.
Options volume has surged more than fivefold in the last decade to 16.7 million contracts a day last year as demand for securities that protect against losses and speculate on the direction of stocks grew, according to data compiled by the Chicago-based Options Clearing Corp.
“You can go down the road and say any institution, whether it be Goldman or any bank, and say it can happen on any given day to anybody,” Ben Schwartz, the Chicago-based chief market strategist at broker Lightspeed Financial Inc., said in an interview. “It’s a positive thing that they react immediately in a timely manner.”
Signs of Trouble
The first sign of trouble came three minutes after the 9:30 a.m. open in New York, when two exchanges owned by Nasdaq OMX Group Inc. announced they were routing orders around NYSE Amex Options. The process, known as self-help and invoked when a trading platform detects errors at a rival, allows them to stop sending bids and offers to the affected exchange until the issue is resolved.
Notices followed in the next five minutes from exchanges run by CBOE Holdings Inc. in Chicago and Lenexa, Kansas-based Bats Global Markets Inc. NYSE’s other platform for equity derivatives, Arca Options, even took the precaution.
By the afternoon Goldman Sachs spokesman David Wells said exchanges were working to sort out the bad trades. The malfunction affected prices for securities with ticker symbols starting with the letters I through K.
Software errors at Goldman caused the firm to spew unintentional orders from the first moments of trading, a person briefed on the matter told Bloomberg News. An internal system that the firm uses to help prepare to meet market demand inadvertently produced orders with inaccurate price limits and sent them to exchanges, said the person, who asked not to be identified because the matter is private.
The scope of the error and any losses Goldman Sachs may suffer are still unknown. While exchanges notified clients about which trades were broken, they have not issued a full account of the results of their reviews. The majority of the reviewed trades at the International Securities Exchange were adjusted and not canceled, based on the exchange’s rules, according to spokeswoman Molly McGregor.
Goldman Sachs “handled it well,” Maidel of Seattle-based Russell Investments said in an e-mail yesterday. “I appreciate the honesty and transparency.”
The New York-based investment bank declined to comment for this story, Wells said yesterday. Representatives of NYSE, Nasdaq, Bats, CBOE and the Boston Options Exchange also declined to comment.
Of the 500 biggest options trades in the first 15 minutes markets were open, 405 of them were for tickers starting with I through K and priced at $1, data compiled by Trade Alert LLC and Bloomberg show. About 113, or 28 percent, have been canceled, the data show. NYSE Amex Options accounted for 67 percent of the canceled trades, compared with 18 percent for the Nasdaq Options Market and 12 percent for the International Securities Exchange.
Citigroup Inc., the third-biggest U.S. bank, sought to profit from the errant trades, according to one person with direct knowledge of the situation. The New York-based company gained millions of dollars by buying and selling mispriced options before exchanges began canceling the trades, erasing much of the profit, the person said.
Danielle Romero-Apsilos, a spokeswoman for Citigroup, declined to comment.
At Entropy Capital’s office in San Francisco’s financial district, Brady’s team pounced on the Goldman error and looked for contracts to profit from. One was September puts conveying the right to sell U.S. shares of ICICI Bank Ltd. at a strike price of $22.
Quotes for the contract were priced at $1, when the fair value should have been about 30 cents, Brady said. His firm was able to sell some of the puts and the transactions weren’t voided, he said. That contract rose as much as 1,155 percent to $2.76 on Aug. 20. It closed at 29 cents yesterday.
“It was kind of disbelief coupled with like a frenzy,” he said. He declined to say how much profit he made on the trades.
In London, Gareth Ryan, the managing director of IUR Capital Ltd., had positions in the iShares Russell 2000 ETF and other securities and watched as the prices of the contracts went haywire.
“We saw quotes on put spreads and call spreads that were way off in the first few minutes,” he said in a phone interview. “It changed our client portfolios significantly at the open but an hour after the open when the spreads came in we realized that something was wrong in the quotes.”
Calls on the iShares Russell 2000 ETF went from $26.23 to $1 within the first five minutes exchanges were open that day. Almost 1,000 of the December 2013 calls that traded at $1 were among the canceled transactions, data compiled by Bloomberg show.
NYSE Amex Options was flooded with the deluge of bad trades as it began scrutinizing each one to determine which to void. The exchange told clients after the close that it wouldn’t complete its review during regular business hours. Officials at other exchanges continued to cancel and adjust trades through the evening before completing the process yesterday.
“The talk from all of the firms was that a market maker was on the other side of those trades, so the trades would be adjusted, not busted,” Mark S. Longo, founder and chief executive officer of Options Insider Inc., said by e-mail. “Clearly Amex received a lot of angry feedback about that decision because they announced later that they would review the trades on an individual basis to determine whether to bust or adjust them.”
“It was a bad deal for everyone,” Longo said. “Goldman clearly lost millions but many of the market makers who took the other sides of those trades could have also lost millions if they hedged.”
Investors in U.S. equity markets have become accustomed to technical breakdowns that disrupt markets, from Knight Capital Group Inc.’s near bankruptcy last year to Bats’s failure to get its own stock to trade in its initial public offering and Nasdaq’s bungling of Facebook Inc.’s IPO. On April 25, CBOE shut its Chicago Board Options Exchange for three-and-a-half hours following a malfunction during preparations for a reconfiguration of its system.
“GS’s recent snafu is the ‘new normal’ in electronic trading, the equivalent of the old fat-finger trade, except that now there’s less of a human safeguard in dealing with them quickly,” David Weiss, a senior analyst at Aite Group LLC, said in an e-mail. “So the vaunted speed and efficiency of electronic trading can greatly magnify the impact.”
Regulators have tightened rules at exchanges to avoid market disruptions such as the May 2010 errors that briefly sent the Dow Jones Industrial Average down almost 1,000 points because of a faulty algorithm in what’s become known as the flash crash.
Under the limit-up/limit-down system implemented this year, trades aren’t allowed to take place more than a specified percentage above or below the average price over the preceding five minutes. If prices don’t move away from the limits within 15 seconds, the market declares a trading pause.
Goldman’s mishap highlighted different rules in the U.S. options landscape, a market that has expanded in five years to a dozen separate exchanges from seven. While the trading platforms are tied together by rules guaranteeing investors get the best prices, they lack uniform guidelines for voiding trades.
Rules on International Securities Exchange say trades with the most basic errors will be broken if they involve someone known as a priority customer, usually an individual, unless they agree to an adjustment price within 30 minutes of being notified. The NYSE cancels a trade if one party isn’t a market maker and both fail to agree to adjustment within 30 minutes. At the Chicago Board Options Exchange, a trade with one or two market makers will be adjusted.
“Each exchange sets its own clearly erroneous trade guidelines but the SEC wants them to be similar,” said Richard Repetto, an analyst at Sandler O’Neill & Partners LP. “In the options world, there’s more room for interpretation.”