The software problem that caused BATS Global Markets Inc. to allow trades that violated rules is a symptom of overly complex market regulations that should be simplified, Chief Executive Officer Joseph Ratterman said.
BATS discovered the problem, which involved almost 450,000 transactions, on Jan. 4 through routine data inspections conducted by its operations department looking for anomalies in trades and how the exchange handles orders, Ratterman said in a telephone interview today. Brokers hadn’t detected it, he said.
The issue allowed technical infringement of rules aimed at preserving fairness in the U.S., where trading is fragmented across 13 exchanges and dozens of other venues. While losses to any single user would have been close to undetectable and the vast majority of BATS trades were executed correctly, the disclosure comes after a year in which breakdowns on exchanges sowed investor concern the nation’s electronic equity infrastructure is too complex to manage.
ALTERNATE VIEW: The system errors at BATS show the need for vigorous technology testing. But they shouldn’t be mistaken for an argument that the markets are too complex. Miranda Mizen, Tabb Group. Click here (Registration required).
“I think you could do away with a significant amount of complexity by simplifying some of the regulatory guidelines,” Ratterman said. “Nearly all the order types and functionality that exists in the market are there to allow trading participants to reflect their interest to trade and to be compliant with the regulatory structure we all live in. If the regulatory environment were to simplify, then the functionality customers demand to reflect their trading interest would simplify as well.”
“Despite automated testing, a plethora of order types makes it virtually impossible to catch every known scenario,’’ said Tabb Group research analyst Miranda Mizen, in an online commentary.
250 Customers
About 250 customers, mainly market-making firms, and 0.004 percent of 12 billion trades on BATS’s two equity exchanges were affected by the problem that dates to October 2008, Ratterman said. About 0.0009 percent of options trades were affected, he said.
While the revelations follow a year of high-profile exchange mishaps including BATS’s withdrawal of its own initial public offering in March, Ratterman doesn’t expect it to derail plans to pursue an IPO a second time.
“We’re going to keep our IPO plans warm,” he said. “We’re just watching the market. We’ll continue to monitor the investor appetite for the securities sector. Coming back is really a matter of timing.”
The Lenexa, Kansas-based company, started in 2005 by a high-frequency trader, operates U.S. equity markets that account for 12 percent of American share volume, compared with about 10 percent at the end of 2010, data compiled by Bloomberg show.
Best Prices
Machines that match orders for two BATS equity exchanges and an options venue allowed some trades to occur at prices inferior to the best nationally 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. Customers lost $420,360 because of rule violations, Randy Williams, a BATS spokesman, said by e-mail.
The BATS problem resulted from what’s called a race condition, Ratterman said, referring to a situation in which computer systems are communicating with each other in real time while new information is being processed by high-speed computers. The mistakes involved so-called price-sliding orders available on BATS that automatically adjust prices in response to changes in a stock’s national best bid or offer, or NBBO. The orders are often used by brokers and professionals to tailor the executions they seek as the NBBO shifts.
‘Very Rarely’
“It’s something that happened statistically very rarely,” Ratterman said. “In a dynamic system with real-time messages between customers and exchanges it’s not completely obvious when you have a race condition like this. That’s why it went on for so long and wasn’t detected by us or our customers.”
See also:
OUT OF ORDER: Are Controls Needed on Choice, Complexity and Competition?
BATS’ Thousands of “Unique Order Type Combinations”
BATS has no plans to eliminate price-sliding orders, Ratterman said. Versions of these orders have existed for years on other exchanges including Nasdaq Stock Market. Regulation NMS, a rule the Securities and Exchange Commission adopted in 2005 and implemented two years later, prohibits exchanges from allowing locked markets, or instances when two venues display the same bid and offer price. The rule exists to increase the likelihood that someone quoting at the best price will receive an execution.
Trading Competition
Regulation NMS aimed to spur competition for stocks listed on the New York Stock Exchange and enable investors to trade faster and with less intermediation. One of its four main regulations was the so-called trade-through rule, which prohibits firms from trading at prices inferior to the best bid or offer on an equities exchange. NYSE, no longer dominant, said last month it would sell itself to IntercontinentalExchange Inc., an Atlanta-based energy and commodities market operator.
“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 Reg NMS, primarily locked markets.”
If the SEC permitted bids and offers on different exchanges to exist at the same price, if wouldn’t be necessary to have order types designed so customers can adjust their trade requests as prices change, Ratterman said. A “significant amount of complexity” would be eliminated, he said.
The SEC routinely reviews trading matters with exchanges as part of its oversight responsibilities, John Nester, an SEC spokesman, said in an e-mail today.
‘Locked Market’
“Here is a case in point where the very fact of a locked market condition caused some complex code that didn’t operate the way it should every single time,” Ratterman said. “When you have Reg NMS involved and prohibitions on locked markets and orders that are sitting on the book that have to be slid back to show a compliant price and new orders — you’re going to have edge-case scenarios.”
Ratterman declined to comment on a potential regulatory response to its errors. Exchanges, which must report likely rule violations to the government, are required to examine their computer systems to ensure they comply with their own and federal rules, he said. The company said yesterday it plans to correct the issue with short sales by about Jan. 18 and the trade-throughs by about Jan. 25.
‘Not Hiding’
“Anytime there’s a compliance issue, there’s a regulatory environment and there are outcomes,” Ratterman said. “We showed we were out of compliance. We’re not hiding behind that. We identified an issue and the impact and remediation, and will move forward.”
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 total 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.
BATS plans to work with the SEC to determine whether it can compensate members harmed by its errors, Ratterman said.
“We have to work through the rules with the SEC and see what our flexibility is,” Ratterman said. “It’s just too early to say what we can and can’t do. Our intention would be to make good with our customers to the extent that we can and the SEC gives us the latitude.”
