It was 3:50 p.m. EST on Wednesday, and the market was stable. The New York Stock Exchange was set to close in ten minutes. A trader posted a trade of 1,100 shares of United Technologies at 11 3/4. The problem was that the previous trade had been printed at 111 7/8. The trader posting the 1,100-share print had left a digit off his quote.
The erroneous trade caused a five-percent tailspin in the Dow Jones Industrial Average minutes before the closing bell. The error turned a 40-point rise in the Dow into a disastrous 257-point drop.
Sound far-fetched? It shouldn't. Trading errors happen all the time.
The lost digit that Wednesday – July 31, 1996 – created a panic on the floor and nearly set off the NYSE circuit breaker for the first time. But six minutes after it appeared on the tape, Big Board officials had unraveled the error and printed a correction, posting the trade at 111 3/4. The Dow was recalculated, and closed with a 47-point gain.
In the impassioned and imperfect world of Wall Street trading, erroneous trades are an accepted reality. Most traders attribute slipups to miscommunication or human error. But as desks rely more on electronic systems to route and execute orders, trading errors have been reduced dramatically.
"Ten years ago, I would say my desk averaged 15 errors a week," said Paul Chalmers, director of international trading at Canaccord Capital in Vancouver. "Today, traders are more careful, and systems handle orders with less human intervention. My desk is down to maybe two errors a week."
Handling Errors
Dozens of situations can lead to an erroneous trade. Stock symbols assigned incorrectly. Selling shares for a buy order. Assuming order information. Moving too many – or too few – shares.
Generally, trading veterans outgrow youthful recklessness and take care to handle orders more efficiently. Learning from past mistakes is part of that maturing. Richard Holway, director of equity trading at Investment Advisers in Minneapolis, still remembers every detail of his first error. He has handled every order since with greater caution.
"A portfolio manager asked me to buy 12,100 shares of ADP, Automatic Data Processing," Holway recalled. "Even though its referred to as ADP, its stock symbol is AUD. I entered the order as ADP, and wound up buying shares of Allied Products."
After that mistake, Holway began echoing the corporate name and stock symbol to the portfolio manager sending him an order.
When an error has been made and the order executed – like in Holway's mistake – the execution will stand. The desk making the error will take the position as a holding of its own, and will fill the customer order as originally intended. The inadvertent order is never the responsibility of the customer.
Because most desks will absorb a trading error as a holding of its own, many firms establish an account to handle positions obtained through errors.
But not all mistakes turn out to be disasters. Tom Norby, head trader at Black & Co. in Portland, relayed the story of a sloppy trade turning a profit.
"A position trader at a firm we deal with was forced into a print of a stock he didn't own," Norby said. The trader, in effect, sold stock to a customer to fill an order without owning shares of that stock. Normally, a trader who has shorted a stock buys the necessary shares later in the day, hoping to fill the order at a price slightly lower than the current quote. But the position trader was unable to fill the order before the close of the trading session.
Ending the day short can be disastrous. If news about a stock breaks before the market opens the next day, that stock's price could climb, and a trading desk could be forced to pay a higher price to obtain shares. Committed to selling the shares at the lower price of the previous day, the desk would incur a loss.
But this position trader – short 500,000 shares – was lucky. News before the opening negatively impacted the price of the stock, driving it down. "The desk was able to buy the shares to fill the order at a much cheaper price than it had sold the shares," Norby said. "The sloppy trade allowed the desk to turn a profit."
Norby and Chalmers – like all sell-side traders – are dependent upon order flow, so they stressed a willingness to absorb mistakes for clients.
"We'll bend over backwards to try to smooth out an error," Chalmers said. "We look at it as if the client is always right, and we work to get that position cleared."
Although usually willing to take a position with an erroneous trade, Chalmers said his desk will investigate the order trail to determine how the error was made.
"Our trading lines are recorded, so we can check who made the mistake," Chalmers said. "Even if the mistake is not ours, we will usually take the hit, but we want the client to know who made the error."
A few months ago, Chalmers telephoned a client's chief executive to say that one of the client's traders had made five errors with Canaccord in six weeks. Covering all five mistakes for the client, the errors were a significant burden to Canaccord's account. The chief executive apologized, and agreed to increase his order flow to Chalmers as restitution.
"The majority of the time, people try to help each other out to clear an error," Chalmers said.
But erroneous trades are not always worked out amicably. If both sides of a trade are positioned in the market as adversaries – like a market maker and a day trader – the desk making the error will often wind up with the position.
Exchange Policies
When an error between two individuals cannot be worked out amicably, exchanges offer alternatives for settlement.
At the NYSE, a trader or floor broker with an unresolvable error can either file for an arbitration proceeding or agree to a judgment from NYSE floor officials.
A judgment by floor officials is the more widespread of the two formal alternatives, and an NYSE source cited the immediate, impartial rulings as the reason for its popularity. When an error must be cleared, floor officials – member floor brokers and specialists – promptly convene with the two parties on the floor and offer a ruling, understood to be final by the two disputants.
Somewhat less popular, but decidedly more official, arbitration proceedings can take months to offer a decision and clear an error. The arbitration decision – handed down by an independent NYSE panel – are also considered final. An arbitration decision can only be appealed on extremely narrow grounds.
The National Association of Securities Dealers also holds hearings for members before an independent arbitration panel. When an error cannot be worked out between two parties, a source at the NASD said that arbitration is the means by which the error can be cleared and capital reallocated.
The NYSE and the NASD offer arbitration proceedings to members for all transaction errors, irrespective of where the trade was executed.
A complaint can be filed with the NASD to alert the agency of a problem with a member firm. But an NASD source stressed that filing a complaint will not settle a trade dispute. Rather, a complaint will alert the agency of an ongoing problem, resulting in an investigation by the NASD's regulatory subsidiary, NASD Regulation. Last year, 5,000 complaints were investigated.
When an error results from a processing mistake – like the missed digit in the United Technologies trade – the NYSE's floor-operations staff will team with floor officials to investigate the reporting mistake. The mistake is corrected and filed with NYSE market surveillance.
On Nasdaq, features of the electronic systems have significantly limited processing errors. With a computerized order trail, erroneous trades can be tracked and corrected quickly.
Electronic Safeguards
Across all markets, the widespread use of electronic trading systems has markedly reduced the occurrence of processing errors on desks. Industry vendors market products designed to reject erroneous trade data entered on workstations. Most programs provide pop-up screens, enabling traders to quickly review data before an order is transmitted for execution.
TradeRoute, a routing system for small institutional-sized equity orders sold by Boston-based AutEx, touts its ability to protect traders from processing errors. (AutEx is a unit of Thomson Financial Services, parent of Securities Data Publishing, publisher of Traders Magazine.)
"We promote the fact that our system eliminates mistakes," said John Spensieri, TradeRoute's business manager. "TradeRoute prevents errors by eliminating exposure where errors occur."
Spensieri cited front-end safeguards that will cancel any order entered with an invalid symbol or trade size. After a valid order is entered, the system requires the sender to review trade information and approve the routing of the order.
Most TradeRoute orders are executed within minutes, so traders are alerted to erroneous trades almost immediately.
"It is so important to catch an error quickly," Holway said. "The worst errors are the ones you don't catch right away. The ticking time bombs."
On Nasdaq, the Automated Confirmation Transaction system (ACT) sets time limits for reporting trade details, helping to keep erroneous data from festering.
ACT is the automated Nasdaq service that receives and matches trades for transmission to the National Securities Clearing Corp. prior to settlement at the Depository Trust Company. In addition, ACT disseminates last-sale information, and sends same-day confirmations and reconciliations to traders. Participation by NASD member firms is mandatory.
Market makers are required to enter trade details on all transactions within 90 seconds of execution. Order-entry firms have 20 minutes to report details of orders executed by market makers. Under certain circumstances, firms must decline and cancel trades entered in ACT.
Clearing firms that execute and process trades for smaller broker dealers have an electronic link to ACT, which helps monitor their correspondents' trading activity and market exposure. ACT will automatically flag the clearing broker whenever a correspondent has exceeded the clearing firm's credit parameters.
A trade is locked when both parties enter identical details. A locked trade is then routed directly for settlement. A trade executed on SOES, for example, is immediately locked.
But no system will eliminate every human error. "You can never get around inputting wrong information," said John Davidge, sales manager of New York-based Davidge Data Systems, operator of DAVNET, an order-routing system. "Systems don't make mistakes, people do."
Indeed. On March 26, 1992, two clerks at the former Salomon Brothers began routinely entering computerized sell orders in some of the NYSE's biggest stocks two minutes before the market close. But the clerks had misinterpreted the order to sell $11 million of stocks as 11 million shares.
The sudden wave of sell orders drove stock prices lower as traders on the floor scrambled to find matching buyers. The Dow, which at 3:58 p.m. EST had been up nearly 13 points, finished down 1.57 points. At the time, Big Board sources said the entire loss in the closing minutes was attributable to the Salomon trades.
Because the orders were executed validly – prices and symbol information were correct – the trades could not be canceled. Salomon was handcuffed to the inadvertant position, which was estimated to have cost the firm $500 million.
