April 04, 2012

In the week since a software glitch disrupted the initial public offering of BATS Global Markets, some experts have focused their attention on the idea that a rogue algorithm deliberately continued to sell BATS shares on a rival stock exchange.

According to research by Nanex, a provider of a streaming whole market data feed, an algorithm executed 567 trades on the Nasdaq Stock Market and pushed the price of BATS from $15.25 down to a few pennies – all within 900 milliseconds, or less than one second.

The theory of a malicious attack by a Nasdaq algorithm to take down its rival stock exchange was circulated by the finance blog ZeroHedge. The blog cites research from Nanex, the Winnetka-Ill., based firm, which posted online a spreadsheet showing all the bids and offers in BATS shares from Nasdaq.

According to Nanex CEO Eric Hunsader, Nanex was able to identify the algo executing on Nasdaq because a lot of the noise was taken out of the market, since none of the other venues were quoting or trading the stock. However, according to an entry in Nanex’s blog, Zero Hedge is incorrect in saying this was a Nasdaq algo. All that is known is that the algo executed on Nasdaq, but the ownership of the algo has not been disclosed to the public.

“Nasdaq was the only exchange out there in these few seconds of time that is quoting and trading the stock,” said Hunsader. “This is completely out of BATS control and has nothing to do with BATS’software,” says Hunsader.

Exacerbating matters further, the algorithm was using an Intermarket Sweep Order or ISO, an order type created under Reg NMS, which allows the trader to scoop up liquidity on a single exchange and ignore better prices on other venues.

Advanced Trading reached out to Nasdaq, but an exchange official declined to comment on the record. The official did, however, point to public information about the steps that Nasdaq had taken last Friday. Advanced Trading also asked BATS if their executives thought that a single algorithm could have hammered its stock price. A BATS spokesperson said it had no comment on the executions, but added, “The software glitch which led to the halt of BATS shares was our issue alone.”

But other seasoned market observers are puzzled as to what happened to the liquidity providers and market makers that provide bids and offers on multiple exchanges. Larry Tabb, founder and CEO of Tabb Group, said it was difficult to figure out what happened from the Nanex data. But Tabb recalls seeing the 1.2 million shares of BATS print on the tape at $15.25, and then the price went down to a penny or two.

On Tabb Forum, an industry discussion board, Tabb questioned why there weren’t buyers on Direct Edge, Arca or the other markets. “Why did it (BATS) only trade in Nasdaq? Did everyone shut off except on Nasdaq?,” asked Tabb. “Was there only a large seller that pounded the stock into the ground? The whole thing is pretty odd actually,” commented Tabb. Other market observers speculate that the collapse of BATS IPO had to do with the rapid trading that occurs on the 13 stock exchanges and reactions by algos to the differences in the speed with which venues update their prices from direct feeds.

Click here for video of Nanex's exchange routing simulation, which depicts the way an exchange views stock prices on rival venues.

“I think the type of rapid trading that occurred as soon as the opening trade hit, combined with a disappearance of market makers, caused a liquidity vacuum,” says Sal Arnuk, a partner in institutional agency broker Themis Trading. “And that liquidity vacuum is very similar to the mini-flash crashes you see on a daily basis,” observes Arnuk.

“Was it a malicious algo that was sent to embarrass BATS? I’m not sure if we’re qualified to say that,” admits Arnuk. However, he continues, “The nature of the very quick trading by algorithms which only value a security based on the immediate data points to the left and to the right of it is dangerous,” says Arnuk.

He also cites other research by Nanex showing the 13 U.S. equity exchanges interacting with each other in real time with flows of data operating at different speeds. “There’s no shortage of different speeds in the market, and when that happens … market makers pull out because their algos are designed not to value a security, but to collect a rebate,” he says.

“When the pricing of assets is determinant on algorithms that are trying to collect a rebate, they are susceptible and turn off at the sight of a data disruption,” Arnuk adds. “You have these liquidity vacuums and they do terrible things to investor confidence.”

As for the conspiracy theory of a malicious algorithm sent to destroy BATS from entering the IPO space -- where it would compete with Nasdaq and the NYSE for corporate listings -- that topic remains unresolved. Only BATS and Nasdaq actually know what really happened and they haven’t release this to the public, note industry sources. However, Hunsader says it would only take regulators about five minutes to investigate it and he’s sure that they have. “Someone needs to figure out who is behind this one,” he says. “This is probably the fastest destruction of wealth in the history of an IPO.”

ABOUT THE AUTHOR
Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in ...