Commentary: Making Sense of Exchange Liability
To What Extent Should Exchanges' Liability Be Limited
Traders Magazine Online News, August 27, 2012
The Flash Crash, Facebomb, and Knightmare have demonstrated our market's vulnerability to technology glitches. The Facebook IPO debacle raises the interesting issue of exchange liability for trading problems. Current SEC-sanctioned rules limit the liability of an exchange for trading losses. For example, Nasdaq Rule 4626 limits Nasdaq's payments to $3 million in any one month. Other exchanges have similar rules on their books.
Do these rules make sense in the modern world of for-profit exchanges? Normally we expect individuals and businesses to be responsible for any damage they cause. This creates the proper incentive for people to engage in appropriate risk management actions that mitigate risks and contain damages. A lack of liability could lead to reckless actions as someone else will bear the costs. So, from the 30,000- foot level, it seems reasonable that an exchange should be just as liable for damage it causes as any other company.
But what kind of damages should an exchange be liable for? Lawyers have long drawn a distinction between direct damage and indirect, or consequential, damage. Direct damage would occur if an exchange employee in its data center negligently damages hardware belonging to an exchange customer. It is pretty clear that in such a case the exchange should be liable to repair or replace the hardware.
However, indirect or consequential damage is a much grayer area. Indirect damage consists of other downstream losses. For example, if a dry cleaner damages a suit, there is direct damage to the suit. Indirect damage would be the lost business opportunity because the suit owner was not properly dressed for a job interview. In the exchange example above, a consequential damage would be the lost revenue the customer suffered while the hardware was out of service. Likewise, failure to properly execute an order could lead to losses - or gains.
What is an exchange's liability in such situations? This is a fascinating legal question regarding the role of government-approved exchange rules, exchange contracts with members, and more. However, I am not now and never have been a lawyer, so I will leave legal analysis to them. I will address the economics of the situation: What should the liability be going forward? Eventually, lawmakers and judges usually opt for the economically efficient rule for society in the long run. (Of course, as Keynes pointed out, in the long run we are all dead. I'm not holding my breath waiting for such outcomes. Sigh.)
In the modern electronic world, competing for-profit equity exchanges operate on razor-thin margins. These systems process millions of transactions flawlessly on a daily basis. Yet any technology can fail. Despite all of our best efforts, airplanes sometimes crash. Airlines can and do buy insurance for such incidents. However, insurance actuaries can predict airline losses accurately enough to offer such insurance on commercially reasonable terms. This is not the case with trading systems. The unpredictable nature of exchange technology failures makes it infeasible for insurance companies to offer such a product on commercially reasonable terms.
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