Exchange Halt Shows Perils of Complexity Beyond Stocks

The price-feed malfunction that briefly froze U.S. options exchanges yesterday shows the dangers of a fragmented market structure go beyond equities trading.

All 12 U.S. options venues temporarily shut, with firms from CBOE Holdings Inc. to Nasdaq OMX Group Inc. citing errors within the Options Price Reporting Authority. NYSE Euronext is looking into whether a software upgrade at its Securities Industry Automation Corp. subsidiary, which administers the feed, was to blame, said Rich Adamonis, a company spokesman.

“These markets are very complex with 12 exchanges and rising volume of quotes and trading activity,” Andy Nybo, head of derivatives research at New York-based Tabb Group LLC, said in a phone interview. “Any disruption in a data feed or in a data system will have a cascading effect. The industry is facing significant challenges with increasing data loads.”

The interruption came three weeks after Nasdaq OMX’s system for distributing U.S. stock prices failed, prompting a three-hour halt for thousands of companies. In the aftermath, securities regulators told exchanges last week to collaborate on preventing more shutdowns.

The options market saw disruptions yesterday morning, according to Christopher Rich, head options strategist at JonesTrading Institutional Services LLC in Chicago.

Manual Orders

“We had issues with a couple of options classes and had to manually place orders on exchange floors,” he said.

Then, exchanges began to shut. Bats Global Markets Inc. closed its options venue at 1:30 p.m. New York time and kept it shut for 40 minutes. The OPRA feed was down from 1:40 p.m. to 1:50 p.m. New York time, Adamonis said.

The effect on volume was limited. About 14 million options contracts changed hands in the U.S. yesterday, in line with the average volume over the past 22 trading days, according to data compiled by Trade Alert LLC.

While trading continued without disruption on American equity markets, stock prices slipped around the time of the mishap. About 614 million shares traded on all exchanges between 1:30 p.m. and 2:30 p.m. New York time, compared with 499 million in the preceding hour, according to data compiled by Bloomberg. The Standard & Poor’s 500 Index fell from 1,702 to below 1,698 between 1:30 p.m. and 1:43 p.m.

In a meeting with the heads of U.S. securities markets last week, Mary Jo White, the chairman of the U.S. Securities and Exchange Commission, urged the executives to shore up price feeds that serve investors and traders.

SEC’s Order

Participants included representatives from U.S. stock and options exchanges, the Financial Industry Regulatory Authority, Depository Trust & Clearing Corp. and Options Clearing Corp. They were told to “provide comprehensive action plans that address the standards necessary to establish highly resilient and robust systems for the securities information processors,” the SEC said in a statement. That includes “testing standards and disclosure protocols,” it said.

On Aug. 22, Nasdaq’s computers were flooded with data from NYSE Arca, a competing exchange, revealing a bug in Nasdaq’s securities information processor for stocks that disabled systems that should have prevented the malfunction from snowballing.

Yesterday’s error “was only a short outage,” Daniel Brady, president of San Francisco-based trading firm Entropy Capital LLC, said in a phone interview. “Not that significant,” he said. “I imagine this is just further fodder for the SEC and their review.”

Market Complexity

“As is our practice, we have been monitoring developments and discussing them with market participants as appropriate,” said John Nester, an SEC spokesman.

American exchanges have faced criticism that the complexity of their electronic infrastructure makes them vulnerable to breakdowns. In addition to the Nasdaq halt on Aug. 22, options markets were roiled in August when Goldman Sachs Group Inc. bombarded exchanges with erroneous orders due to a computer malfunction.

In April, the Chicago Board Options Exchange was down for 3 1/2 hours because of a software error caused by preliminary work in preparation for a computer system reconfiguration. The outage prevented investors from trading options based on the VIX gauge of volatility and the S&P 500, which CBOE has exclusive rights to.

According to OPRA’s website, each trade that is executed on an options exchange is reported to OPRA as a message, with quote message traffic representing the vast majority generated.

Tighter Rules

“Quotes are generated automatically for individual options series based on changes in the underlying stock price or index value,” it said. “In other words, every time a price changes for a particular equity security, the quotes for all of the options on that security or an index in which that security is represented are automatically updated on each exchange that trades those options.”

Regulators have tightened rules at exchanges to avoid market disruptions such as the May 2010 plunge known as the flash crash, in which the Dow Jones Industrial Average dropped almost 1,000 points because of a faulty algorithm.

Yesterday’s problems in the options market highlight the need for exchanges to have better backups, said Randall Warren, who oversees about $100 million including options as chief investment officer of Warren Financial Service in Exton, Pennsylvania. The SEC told exchanges last week to develop plans to bolster price feeds and assess the “robustness and resilience of other critical infrastructure systems,” according to a Sept. 12 statement from the regulator.

“When you need the systems to trade, they need to be in place,” he said in a phone interview. “The exchanges need to get serious about their backup plans and test them out in real time. The backup system should kick in in situations like this and you shouldn’t miss a beat.”

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