SEC Investigates Problems at Stock Exchanges

By Cydney Posner

An article in The New York Times reports that, in the wake of the problems with the Facebook IPO, the SEC is investigating Nasdaq and has also been conducting inquiries at some of the other exchanges. The article also adds more details, quoted at length below, to the Facebook market debut narrative.

As has been widely reported, Nasdaq has blamed its Facebook debacle on "computer problems." (I use that excuse a lot too….) However, the article reports, the SEC suspects that "it may be something more. The Securities and Exchange Commission has opened an investigation into the exchange for its role in the initial public offering of Facebook, according to people briefed on the inquiry. Regulators are examining whether Nasdaq failed to properly test its trading systems, which broke down during the I.P.O., and whether the exchange violated rules when it rewrote computer code to jump-start trading."

The article argues that a lack of communications and (compounded by a lack of contrition) aggravated an already fraught situation. "Nasdaq's computers were programmed to accept last-second modifications to orders of Facebook shares. When these trades kept piling in, the system reset the price over and over again. Some orders were not executed — or were placed at prices other than the opening bid of $42. Many traders, who usually receive confirmations in seconds, had no idea how many shares they held. ‘We were flying blind,' said one person at a market-making firm."

"The S.E.C. is examining why Nasdaq lacked an action plan for navigating such a crisis, including plans to abort the I.P.O., and whether it failed to follow federal guidelines in running system tests. Nasdaq did run some 400 tests ahead of the Facebook I.P.O., and the company used the system in question for more than five years. [Nasdaq CEO Robert Greifeld] has publicly blamed ‘design flaws' in the system."

"Ultimately, Nasdaq overrode the system manually, switching to a backup server. That move, too, has drawn scrutiny. Exchanges must follow their own strict trading procedures. In this case, Nasdaq changed its procedure on the fly without amending its rules. While the exchange may not have followed the letter of the law, a person close to Nasdaq said that the company had previously used the backup system with approval from regulators."

"Shares started trading at 11:30 a.m., sending brief applause through Morgan Stanley's trading floor. The Facebook team, which had been hoping for a 5 to 10 percent jump from the offering price of $38, was relieved when it rose. The team headed to Teterboro Airport to fly back to California."

"Then at 1:50 p.m., a second wave of confusion ripped through Wall Street. Traders saw an unexpected sell order of roughly 11 million shares. Some wondered whether a big hedge fund had dumped shares. Investors, on the fence about buying, backed off. Others sold. Within minutes, Facebook slipped $2, to roughly $40."

"There was no mystery hedge fund seller. As Nasdaq started processing trades backed up in the system, those shares were dumped on the market, according to people with knowledge of the matter. About the same time, some Facebook shares that had ended up in an account at Nasdaq were also sold without warning. The move may have violated Nasdaq's own rules, which do not explicitly allow the exchange to take a position in the shares of an I.P.O., according to one of the people."

"While some analysts have pinned Facebook's woes on Nasdaq, others have blamed the company and its bankers for being too aggressive on the size and price of the offering."

"Facebook shares ended that first day at $38.23, roughly where they started."

"Two days later, Mr. Greifeld called the I.P.O. ‘quite successful' over all and said that technical issues had not affected the price."

"Facebook's management team, which was beginning to grasp the extent of the problems, was livid. Some wondered why Nasdaq had made little effort to keep them apprised on Friday and kept them out of decision-making."

"Mr. Greifeld called a senior executive, asking how the exchange could get back into its good graces. The executive erupted. ‘Bob,' the executive said, ‘You don't understand what a hole you're in.' 

"Nasdaq soon aggravated the trading woes. The exchange informed traders it might offer ‘financial accommodation' for claims filed on Monday. Some investors dumped shares, to prove a loss."

"In the first hour of Monday trading, Facebook plunged from $38 to less than $34, swiftly wiping out billions of dollars in market value."

The article also reports that the SEC is conducting broader inquiries into trading breakdowns and other problems at the nation's largest exchanges (possibly a dozen other related cases), including two previously undisclosed cases involving the NYSE. The issue is whether the exchanges "lack adequate controls and favor select investors." One concern is that these glitches contribute to losses in investor confidence in the market: Senator Jack Reed told the NYT that "'If exchanges have technical problems, that slows capital formation and erodes the confidence.' "

Among the incidents of "technical malfunction" at various exchanges are the cancelled BATS Global Markets IPO (BATS has acknowledged receiving an inquiry from the SEC), dozens of prior instances of technically induced trading halts by Nasdaq and the 2010 "flash crash." The SEC has also imposed penalties on the Direct Edge exchange for having "weak internal controls," and is pursuing the Chicago Board Options Exchange for "not properly policing the market." According to the NYT, the "crackdown represents a significant shift. Traditionally, the agency has been relatively cozy with the industry [remember that the exchanges act as regulators too], which is increasingly under pressure to produce profits since the exchanges became publicly traded companies. Along with the threat of enforcement cases, the S.E.C. has stepped up its inspections of exchanges and introduced several measures to improve the safety of the markets. For example, the agency has approved proposals that would help limit volatility in specific stocks, including circuit breakers that would halt trading. (See my article of 6/1/12.) " Apparently, the SEC believes that these "breakdowns may point to more fundamental issues."

The article reports that the SEC is "also examining whether some exchanges give undue priority to high-frequency trading firms and big institutional investors through its order types and data disclosure. The New York Stock Exchange is among the most prominent players facing scrutiny from regulators, who have opened two investigations into the Big Board, according to people briefed on the matter who spoke on the condition of anonymity because the cases are not public. The S.E.C., the people said, is examining whether the New York exchange violated rules by distributing in-depth stock data to paying clients faster than the public received general information. The issue was first discovered in the rubble of the flash crash. The exchange declined to comment. But people close to the exchange have attributed the problem to unintended technical shortcomings."

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