(Bloomberg) — U.S. regulators called on top exchange officials two years ago to strengthen the plumbing that underpins the stock market after a series of trading disruptions.
The exchanges did an analysis and concluded they needed a backup plan for the crucial 15-minute closing auction each day when traders are guaranteed theyll get the final price. Yet when the New York Stock Exchange suspended trading for hours on Wednesday, there were unanswered questions.
A high volume of stock trading takes place during the close. While Nasdaq OMX Group Inc. and NYSE say they have plans to ensure theyll be be operating during the end-of-day auctions, neither exchange has a failsafe in place to guarantee there will be closing auctions if their systems go awry.
The NYSE shutdown, sparked by a software upgrade, highlighted the lack of a plan, with exchange officials telling customers during the afternoons outage that failure to restart by about 3 p.m. would mean the cancellation of that days closing auction. The halt of the auction could have caused chaos and been costly for investors since a benchmark index was reconfiguring its membership. That means the index funds that track the benchmark would have struggled to lock down closing prices as they swapped shares of the old member in the Standard & Poors 500 Index for the new member.
We came perilously close to not having closing prices on a day with significant S&P index changes, and the industry needs a better contingency plan in place, Dave Lauer, co-founder and chief technology officer of market research firm Kor Group LLC, said in an e-mail.
No Harm
The Securities and Exchange Commission is now going to press the exchanges and member firms to create formal contingency plans for closing auctions, said a person familiar with agency deliberations who asked not to be named because the deliberations arent public.
Sara Rich, a spokeswoman at NYSE, declined to comment.
NYSE Group President Thomas Farley highlighted the importance of the close of the exchange during a Bloomberg Television interview Wednesday saying its when the market consolidates around the NYSE and the biggest trades of the day occur.
So my first concern was, do no harm during the day — those stocks continue to trade elsewhere — get the problem fixed and get it back up and running for the close, Farley said.
Arca Backup
Nasdaq doesnt have established procedures for what to do in the event of its closing cross, or auction, being canceled because the company makes sure that such an event wont happen, said Donald Beery, vice president of global operations.
We have two different applications that run every single day and if either fails the other one is there and if both fail we have an offline cross that also runs every day and is calculating the prices, Beery said in a phone interview. We will always have a closing cross.
There are potential backup solutions if exchanges arent up by the end of the day, such as alternate exchanges providing support. One reason for the lack of a contingency plan is that brokers dont want to pay for separate connections to other markets, according to one person with knowledge of discussions. The person familiar with SEC deliberations said the agency has tended to agree that costly additional connections might not be necessary for a workable backup.
NYSE has tried to designate its Arca venue as the backup, most notably before Hurricane Sandy struck the New York region in 2012. Wall Street balked, saying sufficient testing hadnt been done, and the U.S. equity markets instead closed for two days. In this weeks outage, the exchange told clients that if it failed to reopen it would calculate closing prices based on the final trades taking place elsewhere in the market, as trading continued on many other venues while NYSE was down.
Family Dollar
On Wednesday, the situation was complicated because Family Dollar Stores Inc. was being replaced in the S&P 500 by Advance Auto Parts Inc.
NYSEs auction normally kicks off at 3:45 p.m when orders sent before it starts are collected and published. Once the auction has begun, NYSE frequently sends information about the quantity and prices of bids and offers for a stock. If theres an imbalance between supply and demand, traders can send orders that will help find a balance.
All orders sent to the auction are filled at the final price determined by the process, which is the official closing price for the stock. Thats the price used by indexes and funds to calculate their end-of-day values.
Trading Vulnerabilities
On a typical day, funds tend to trade heavily in the close to make sure they get the official days price of a stock as they buy and sell to meet their investors demands. When an index rebalances, index-tracking funds focus on the auction to ensure they stay as close as possible to their index.
If NYSE hadnt been able to resume around 3 p.m on Wednesday, one option for funds would have been to find a broker who could guarantee beforehand that theyd match the closing price — something that would probably have increased costs and created confusion across Wall Street.
SEC Chair Mary Jo White expressed her concerns about stock trading system vulnerabilities in September 2013 when she called the heads of the exchanges to Washington to scold them about a series of malfunctions and said they needed to ensure the robustness of the market. The exchanges acknowledged the importance of backup plans for the daily market close in a joint statement issued in November 2013 in their response to that meeting.
Notable Failures
White subsequently said in a June 2014 speech that the agency was focused on single points of failure that can halt or severely disrupt trading when a problem occurs. She said the exchanges had responded to her call by strengthening their backup facilities on the price feeds.
Under separate SEC rules taking effect in November, exchanges must ensure trading can resume within two hours if critical systems such as those used to conduct the closing auction go down.
There have been two notable failures of the closing auction in recent years. In March 2009, Nasdaq canceled its auction, instead setting its official closing price on the trade done an instant before 4 p.m. New York time.
In November 2012, NYSE stopped trading in 216 securities and canceled the closing auction after a computer outage. NYSE published official closing prices for the securities at almost 5:30 p.m.
While the NYSE outage showcased the resiliency of our fragmented market, it also made many participants nervous because of the industrys reliance on NYSEs closing auctions, Kor Groups Lauer said, referring to Wednesdays halt.
