BackSebi on right track with trade annulment policy
Sebi may soon initiate a public consultation on ways to handle erroneous trades
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Securities and Exchange Board of India’s (Sebi) next discussion paper could well be one on trade annulment. According to a Press Trust of India report, Sebi may soon initiate a public consultation on ways to handle erroneous trades, as well as (seemingly erroneous) orders entered by manipulators intentionally to make illicit gains.
This column has argued that having a clearly laid out trade annulment policy on the lines of what the Securities and Exchange Commission did post the May 2010 flash crash will remove any ambiguity about the validity of these trades. Earlier this month, National Stock Exchange (NSE) communicated to Emkay Global Financial Services Ltd that the erroneous trades done by one of its dealers will not be annulled.
Emkay has now approached Securities Appellate Tribunal (SAT) challenging the decision and the first hearing in the matter is set for 19 June. The trades were done in early October, and it looks like the issue will not be settled until at least nine months have passed since the incident. Annulment of trades, if necessary, should be done as close to the trade as possible. Most counterparties in the Emkay trade have already received their payouts -- to now ask them to forfeit those gains and surrender them back to the exchange will be grossly unfair. But even if an errant trading member requests it soon after the trade, an annulment of trades is best avoided. It must be noted that traders now make simultaneous trades in different securities and asset classes. If the ‘erroneous’ leg of such a trade is annulled, counterparties to the trade will be unwittingly left with an open position. It must be noted here that Emkay’s erroneous order resulted in a total of 60,000 trades with 14,000 separate counterparties. Reversing these many transactions will be a nightmare for the exchange and unfair for the counterparties, most of who closed out their positions soon after markets resumed trading after the brief halt.
Having said that, there may be instances where an annulment of trades is warranted. NSE’s current byelaws state that the exchange will determine if the trade is fit for annulment on account of fraud or wilful misrepresentation or material mistake in the trade. Sebi’s trade annulment policy must be far more specific. For instance, the US SEC’s trade annulment policy allows exchanges and the Financial Industry Regulatory Authority (Finra) to cancel freak trades when more than 20 stocks were involved and the price movement is greater than 30%.
According to reports, Emkay has also argued that its losses would have been lower if the markets had automatically halted when the Nifty index fell by 10%. As it turned out, the index fell by more than 15% before trading halted. But it must be noted here that while there is an index-level circuit breaker, there were no such price limits on the individual stocks that comprise the index, and so buyers and sellers could post quotes beyond this 10% limit. (Sebi only later introduced new limits within which traders have to trade quotes for individual securities).
Since Emkay placed an unusually large index basket sell order, which got automatically broken into separate orders for individual stocks, its order sliced through the entire order book, before any brakes could be applied by the exchange. SAT can consider whether the broker’s losses should be curtailed at levels when the index fell 10%. Annulling the entire trade, however, will not send the right signal to the markets. The Emkay episode, as well as similar, albeit smaller, trading mishaps at some other firms should alert the trading community about the risk management they have in place. If the trades are annulled, risk management will not be done with the same seriousness. Emkay’s erroneous order itself was the result of lax risk management, with no dealer-level limit set on the terminal from which the order was sent.
Besides, as the regulator has rightly identified, some seemingly erroneous trade may be part of a larger fraudulent trade.
While the Emkay trade clearly doesn’t fall under this category, traders can attempt to make gains in other securities or even other asset classes by distorting the price of a security or index through a seemingly erroneous trade. It will be ironic if such as trader can keep the gains in the other securities, while the losses are waived because of an annulment of trades. Of course, such trades will come under the larger purview of fraudulent trades; but the trade annulment policy must bear this possibility in mind.
Your comments are welcome at inthemoney@livemint.com
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