Are You Really Protected From the Next Flash Crash?

Pop Quiz:  Let’ s suppose, hypothetically, you are  trading a non-Russell 1000 stock.  All of the sudden, out of nowhere, the network at a major exchange is hacked by some foreign intruders.  Data becomes corrupted and the high freak “liquidity providers” head for the exits as fast as they can.  Stop limits are being triggered everywhere and the phantom bids that represent today’s equity market have all but vanished.  Your sell order gets executed 29% away from the last trade.  Exchanges are able to quickly locate the source of the network intrusion and shut down the hackers (we know, not likely, but just play along).  The stock you were trading quickly recovers after it brief loss and is now back to trading at its pre-hack level.  In addition to your trade that got executed 29% lower, there were over 200 other “bad trades” that were executed far from the reference price. Question for you:  Does the exchange break your trade since it was “clearly erroneous”?

If you answered “No”, then you are correct.   How can that be, you say.  Didn’t the SEC put in place all sorts of rules since the May 6th “Flash Crash” that would protect your order from this type of situation?  Well, in September of 2010, the SEC approved a little known FINRA rule request (Rule 11892) which created a new category for breaking of “clearly erroneous trades”.  The new rule (which is currently in a pilot program) says:

“With respect to multi-stock events, the amended rule creates a new category-multi-stock event involving 20 or more securities-to address clearly erroneous reviewsregarding executions in 20 or more securities that occur within a period of five minutes or less. Once a multi-stock event is triggered, FINRA will coordinate with the exchanges and nullify as clearly erroneous all transactions at prices equal to or greater than 30 percent away from the reference price in each affected security”

Basically, this means, should there be another “flash crash” type event, where there are over 20 securities with erroneous trades, only erroneous trades 30% or more will be broken For the full list of what will and what will not be broken in case of errors, click here: FINRA notice

So, why are we talking about this today?  Because on Monday, 4/25/11, between 9:28am and 10:02am, 84 stocks traded at prices that were far away from their previous price.  What, you didn’t hear about this?  That’s probably because the alleged source of the problem, NASDAQ, would probably rather not have this story in the press considering they are still playing the Dating Game with the NYSE.  NASDAQ released this post mortem yesterday:

“On April 25, 2011, NASDAQ experienced an issue with the Market Maker Automated Quotation System whereby a subset of securities had invalid market data. This caused the automated quotes in those securities to be posted at aberrant prices starting at 09:28:00. The application that controls these functions was updated and at 10:02:42 the system was normalized. NASDAQ has determined the root cause of the issue and has taken steps to avoid the likelihood of future occurrences.”

First of all, what exactly does “experienced an issue” mean?  Was this a computer malfunction or something more nefarious?

Secondly, what is the Market Maker Automated Quotation System?  Well, this is Nasdaq’s recently approved system which automatically  posts quotes for “market makers”.  Click here for FAQS We remember way back when Nasdaq had real market makers that posted their own quotes which were at the NBBO because these market makers needed to trade stocks.  Nowadays, a “market maker” is likely just a machine sitting in a sterile, cold server room that gives instructions to make sure their quotes are far enough from the NBBO so they will not be executed but close enough so they enjoy the privileges of being a market maker.  Rather than discouraging this type of behavior, Nasdaq seems to be encouraging it with their Automated Quotation System.

This little innovation by NASDAQ which was created to assist their automated, high volume clients is just more of what we have seen from the for-profit exchange model.  Make no mistake, the exchanges are in the business of making money first and investor protection seems to be only an afterthought nowadays.  This non-stop quest for profits by the exchanges has been revealing flaws in their models.  This time it was only 84 stocks.  What happens if next time it is 1084 stocks or 4084 stocks?

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