January 10, 2013

It’s another day, a New Year and another embarrassing technical error for a stock exchange.

The admission yesterday by BATS Global Markets that a system issue enabled hundreds of thousands of trades to be executed at incorrect prices over a four-year period raises new alarm bells for investors and traders.

The Securities and Exchange Commission requires orders to be routed to exchanges displaying the best bid and offer. According the article in today’s Wall Street Journal, BATS notified customers on Wednesday, that a systems problem had caused orders to be executed at prices that were “equal to or less than the so-called national best bid and offer price,” which would violate the rules that exchanges are required to adhere to under Regulation NMS.

The problem also impacted short selling in which investors are betting that the price will fall. Short sellers borrow the shares to sell them short, and then buy them back if they drop, pocketing the difference.

This latest technical issue is a black eye for the Kansas City-based stock exchange operator since it follows the software problem that BATS had with its own initial public offering last March, which scuttled the deal. It also falls on the heels of a series of technical snafus including the botched Facebook IPO in May, and then Knight Capital’s $460 million loss in August also related to the release of faulty software.

The string of errors has rattled investor confidence in the computerized stock market and led some leading analysts and market watchers to say it has become too complex and fragile.

In this case, BATS reportedly discovered the issue internally, an anonymous source familiar with the situation told the WSJ. To be fair, BATS deserves some credit for coming forward and announcing the issue publicaly. But why did this persist for four years before anyone detected it?

This may add to the chorus of criticism around the concept of exchanges acting as self regulatory organizations (SROs), which police themselves.

According to comments by market experts on Linkedin, BATS CEO Joe Ratterman told the WSJ that the issue mainly affected market makers who are high frequency traders. Even so, the mistake is not something to be taken lightly.

Although the net amount of the “inferior” prices was less than $500,000, the amount will probably be viewed as a minor blip. After all, Knight Capital lost $440 million in about 15 minutes. But the loss of any amount of money based on the concept of routing to the national best bid or offer is a serious blow to investor confidence since it is the centerpiece of the entire interconnected, highly automated marketplace. Investors who enter an order through their brokers rely on smart order routers to send their orders to the exchange with the best price. Stock exchanges vigorously compete to offer the best price. That is how BATS, an upstart exchange, is able to grab market share from the NYSE, Nasdaq, Direct Edge, etc. In fact, at the end of 2012, BATS, the third largest U.S. equities exchange operator, had It’s best year ever, grabbing 11.9 percent market share in equities, up from 11.2 percent in 2011.

Even if the monetary loss is considered tiny by Wall Street standards, ordinary investors may view this news as evidence that they can’t trust the prices they're getting. That would be bad news for BATS as well as the rest of the industry.

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 ...