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Trading Firms Break A Sweat
Over Breaking Trades

BY MarketWatch
— 3:12 PM ET 05/17/2010

NEW YORK (MarketWatch) -- A growing number of trading firms are criticizing the practice of breaking trades--an uncommon move that has now come under the spotlight after being wielded by the stock exchanges to contain damage from the market's May 6 flash crash.

When trades are cancelled, investors can end up in unexpected positions if earlier transactions are wiped out, but later transactions still stand. Merely the risk of getting caught in such a predicament is enough to discourage some traders from entering a market in free-fall, as it was for 15 minutes on May 6. Later that day, the four main stock exchanges met and agreed to cancel all "clearly erroneous" trades, or those stocks that were sold for 60% above or below their consolidated price listing at 2:40 p.m. that day.

"We're not sure that the 'clearly erroneous' [policy] makes sense, especially since the 'clearly erroneous' levels seemed to be arrived at in a very informal, opaque fashion," said Tom Joyce, chief executive of Knight Capital (NITE). In testimony before Congress, Eric Noll, head of transaction services at Nasdaq OMC (NDAQ), said there was "significant discussion" among the exchanges over where to break trades after the May 6 plunge.

"This incident where all the stock exchanges picked some level and busted trades below that is just crazy to me," said Don Wilson, chief executive of DRW Trading Group in Chicago. Wilson, who has had "hundreds" of futures trades broken over the years, now advocates adjusting prices rather than canceling trades. "In markets where trades may be busted, people in volatile periods tend to just pull out of the markets because they feel the risk of the busted trade isn't worth it."

The exchanges have said they break trades rarely, and only to preserve market order when it has been disrupted by an error or unusual volatility. Guidelines dictate where trades can be busted in the first half hour of market activity if there is significant futures trading, for instance.

"It's very exceptional," said Ray Pellecchia, spokesman for the New York Stock Exchange. He noted that the Securities and Exchange Commission stated after the May 6 plunge that it is reviewing how trade-breaking should be conducted going forward.

But traders worry that someone who has purchased stocks at a low price and then sells them, expecting to have booked a profit, may instead end up short if the earlier purchase is cancelled.

High-frequency trading firms, which have been criticized for pulling out of the market's plunge, have their own reasons for shying away from busted trades. Many of the super-fast, computer-driven trading thrives on darting in and out of the market to take advantage of statistical inefficiencies, not placing long-term bets on companies' performance, so many high-frequency firms like to end the day essentially having exited the market. Broken trades may cause high-frequency firms to find themselves holding a surprise long position and potentially violating their margin requirements, said Manoj Narang, CEO of Tradeworx.

"Breaking trades after-the-fact is a terrible, unfair and arbitrary practice because it causes huge uncertainty and discourages short-term trades from staying involved in the market during volatility spikes," he said.
Most opponents of trade-breaking agree that some new safeguards need to be established to help the market weather extreme volatility. The exchanges' proposed circuit breakers, which would trigger a time-out across the market when any stock or index fell below a pre-established level, are popular within the industry.

"We believe that a circuit breaker [kicking in] at 25% with a five-minute break would eliminate any need to revert to the 'clearly erroneous' approach," Joyce said. The exchanges have yet to unveil the exact parameters of the proposed circuit breakers.

Not all traders object to the concept of breaking trades. Some stress the timing of making the decisions and alerting traders is key. Phil Flynn, a senior market analyst at PFG Best in Chicago, said he lost money while trading Standard & Poor's 500 futures and didn't know a trade had been broken for several hours.

"I was in awkward short position by the time I found out," he said. Flynn said he understood why the trade was broken, due to a mistake in the Chicago Mercantile Exchange's order book in processing a large trade, but his loss of between $5,000 and $6,000 still smarted. "It sure seemed like a huge amount when I thought I made $1,000," he said.