September 11, 2013

Exchange heads are reportedly scheduled to meet with SEC Chairman Mary Jo White tomorrow in Washington, D.C. to talk about the outage involving Nasdaq stocks three weeks ago.

Clearly, the No. 1 issue on their agenda is going to be the technological problem that caused the outage in Nasdaq’s securities information processor (SIP) on Aug. 22nd, resulting in a three-hour shutdown of trading in thousands of Nasdaq-listed stocks across all venues.

Other “critical market systems and infrastructure issues” are also going to come up, said the SEC in a Reuters story on Aug. 27 that reported the meeting on Sept. 12.

After a preliminary internal review, Nasdaq OMX has already said that NYSE Arca had a break in connectivity with its SIP and then in attempting to reconnect multiple times it sent a flood of messages, which overwhelmed the SIP’s capacity. In addition, this process exposed a software flaw in Nasdaq’s SIP, preventing it from failing over to a backup system. Presumably NYSE Arca will also have a chance to present its view of what happened, as will other exchanges, BATS and Direct Edge.

But once they discuss the so-called Flash Freeze, one has to assume the SEC commissioners will grill the CEOs on what they plan to do to prevent a similar event in the future. More importantly, the SEC’s Chairman White should ask how the Nasdaq SIP is performing with respect to implementing the new Limit-Up, Limit Down-Rule (LULD) program to manage order imbalances that can lead to volatility in stock prices. At a media briefing on Tuesday in New York, Jim Toes, president and CEO of the Security Traders Association (STA), said the trade association for equity traders had already expressed concerns in a comment letter about the SIP on “its ability to perform new and complex functions” when the Limit Up-Limit down (LULD) rule is implemented. LULD was proposed as a response to the May 6, 2010 Flash Crash, as mechanism for dealing with market-wide volatility in individual NMS securities. In a recent blog posted Aug. 27, STA leaders question whether the Nasdaq outage was a one-off error like “broken eggs” in a restaurant, or if there’s a “smoking gun” pointing to a more serious problem. Prior to Reg NMS being implemented in 2006, order imbalances were handed by an NYSE specialist who would halt trading, send out an indicative price and then allow the book liquidity to build and then reopen the stock. Now the LULD program is going to perform the role of the specialist, said STA’s blog.

In the media briefing yesterday, Toes said he had SIP concerns on a number of issues. Today, the SIPs take in quote feeds and disseminate them. With LULD, SIPs will take in trade data and quotes and figure out a reference price and display not just quotes but price bands. “When stocks go past those bands, it has to figure out halt reference prices,” he said. The SIP has to calculate prices and then publish the bands, which could turn into a capacity problem.

“For the SIPs, this role is new, complex and core to the overall performance of the LULD Plan. Therefore, it is critical that we understand the connectivity problem NYSE Arca and NASDAQ experienced last week,” STA wrote in its blog.

According to the market-wide limit-up/limit-down plan that was approved on May 31, 2012 for a one-year pilot: “Those price bands would be based on a Reference Price for each NMS Stock that equals the arithmetic mean price of Eligible Reported Transactions for the NMS Stock over the immediately preceding five-minute period.”

The point is there is much more complexity ahead for the SIPs when performing their Limit Up-Limit-Down responsibilities, which could be triggered under stressful circumstances. Today’s meeting between SEC and exchange CEOs is an opportunity to address any potential weaknesses in the market data dissemination system and whether they are vulnerable to more breakdowns. It’s also a time to question whether the SIPs can handle a more complex role, a role that is suppose to make the markets safer.

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 ...