Nasdaq Systems Issue Impacts Short Sales, Points to Ongoing E-Trading Glitches

Nasdaq OMX Group notified customers on Tuesday that short sale orders may have run afoul of the SEC's rules due to a systems issue, according to a report in yesterday's Wall Street Journal.

An unspecified number of orders may have been executed in violation of the SEC's so-called alternative uptick rule, which the agency implemented in 2010 to prevent aggressive short sellers from beating down stocks that had already suffered significant price declines.

The rule, officially known as Reg SHO Rule 201, is triggered after a stock drops 10% in one-day, and then only allows a short sale after a price that is higher than the last trade, reports the article, Nasdaq: Short Sales May Have Flouted Rules.

But the short-sale glitch at Nasdaq could have implications for hedge funds, brokers and proprietary trading shops that make bearish bets on stocks by borrowing the shares and selling them short. They are betting on a price decline at which point they will buy the stock in the open market and return it to the lender, profiting from the difference in price.

This systems "issue" is the latest in a series of technical glitches in the U.S. stock market that is raising concerns about the safety and reliability of the infrastructure. It comes on the heels of Nasdaq's software problems with the Facebook IPO on May 19th followed by the software fiasco at Knight Capital on August 2, which led to erroneous trades that nearly destroyed the electronic market-making firm and forced it to seek a rescue by a consortium of outside investors.

Some capital markets participants are concerned that these shocks to the system are eroding investor confidence. Earlier this week, Tabb Group reported that only 2% of industry professionals rated their confidence in equity market structure as very high.

As some bloggers have suggested, the computerized stock market is proving to be more difficult to keep in line. With so many moving parts, exchanges, ECNs, dark pools, algorithms as well as interfaces, circuits, and protocols, changes in software can cause errors to creep in. While many pundits are urging the industry to invest more time in testing their applications, it appears that exchanges also need to install monitoring systems that catch such glitches. It becomes more evident with each episode, that electronic trading is more complex than anyone realized.