TRADING ERRORS: The Case for Adjusting…Not Busting

We have heard both sides of the debate around the electronic options trading errors from last week.  The truth is, errors happen. They happened well before we had electronic trading but they were rarely publicized.  In the old days, a runner would submit a buy instead of a sell order into the crowd, or trade the incorrect quantity. The speed of these errors were slower, but so was everything else.

Today, it is possible for an exchange to clearly define what an “erroneous trade” is and then have a policy for rejecting the order.  If its clear that a trade was an error “after the fact,” then this definition can be coded onto the systems in advance.

Option customers, market-makers, and brokers are required to have filters to prevent obvious errors. The exchanges may consider this as well. If the trade still managed to pass all the filters, there could be a price adjustment. Cancelling, or busting, trades is a difficult proposition if we rely on market-makers to provide liquidity. Recall that the market-makers will automatically hedge new options positions by trading the stock.  Are they allowed to cancel the stock trades related to hedging the erroneous options trades too?  If so, then the stock specialists will need to cancel their trades as well…and so on and so on. It becomes complicated very quickly.

Simply canceling an options trade is far more dangerous in the options market than in stock or futures markets. Either way, the exchanges themselves as well as all participants should have matching engines and error filters.

Participants on the other side of these errors are certainly motivated by profit, but many are just doing their job. What if this was a flash-crash scenario? Everyone was complaining that liquidity providers disappeared during the flash-crash. What if the error wasn’t an error?  The market-makers were simply doing there job by being there and posting a price even if it was an extreme price. They made a market – they took risk. We can’t both ask them to provide liquidity in all markets and also assume losses for other participant errors after the fact.

Today when the liquidity providers are required to post a price – no matter what – everyone complains that they unfairly profited.  Don’t we want them to provide liquidity always? Or only sometimes?  It would be nice if anyone could simply “do over” after making a “mistake” – everyone would agree to that. However, it clearly is a disincentive to those whose job is to provide liquidity.  Next time we really need the liquidity providers when the market is in turmoil they may not be there.  Maybe a better outcome would be to keep all the trades but to adjust the prices to reflect a more accurate picture in the underlying security.  The erroneous trader may still get hurt in this scenario, albeit less hurt, but the liquidity providers do not get excessive rewards either.

Ultimately, errors happen, the rules need to be very clear. In options markets where there are multiple links and hedges to any order, a price adjustment seems to be the best balance between all the conflicting interests. Traders, brokers and exchanges ALL need to be on the forefront of technology.    Zem Sternberg.

  • abekohen

    Spot on. It would be nice if all options exchanges had the same “error” rules, but I won’t hold my breath.