The Truth About Market-Structure Issues

September 26, 2013

Nasdaq’s halt last month should inspire a wake-up call for all exchanges.

[Editor’s Note: This blog is the first part of a two-part series on the problems with modern electronic financial markets and how to continue fixing them.]

On Aug. 22, the Nasdaq halted trading for nearly a full day, and the event raises a lot more questions about market structure and fragmentation of U.S. market structure than it does about issues at Nasdaq.

After all, the last three years on Wall Street have been filled with trading “glitches.” From the “flash crash” on May 6, 2010, to the BATS IPO, to the Facebook IPO, and most recently—Nasdaq.

We also can’t forget the “internal” glitches that are distinct from exchanges. Goldman Sachs made the list—also in August—with its options desk trading error, which occurred about a year after the trading-algorithm-gone-wild incident at Knight Capital brought the firm to the edge of bankruptcy.

There’s no doubt that investors are now questioning the viability of modern capital markets, and anyone who denies that is simply fooling themselves. Things do seem a little shaky.

But again, it’s important to really separate the core issues from the noise.

First, everyone needs to understand what I’m describing as the internal errors.

What happened at Knight Capital last year and at Goldman this year aren’t issues of market structure that demand immediate regulation and oversight. Those issues relate to internal trading programs that have been poorly tested and implemented.

And if we’re being real here, these are issues that will always happen. Why? Because human beings aren’t perfect. Before electronic trading became the norm, there were traders who were making erroneous trades while entering manual orders.

That’s life. It’s also a little funny.

But what worries me most are the deeper issues, those of market structure that we’ve witnessed in the exchangewide “glitches.”

After Nasdaq shut down last month, it was later revealed that the true culprit was the Securities Information Processor (SIP).

Let’s quickly go over exactly what the SIP does. When a security is listed on an exchange, say, the Nasdaq, it can still trade off-exchange or even on another exchange, such as BATS, or NYSE ARCA.

However, the exchange that’s in charge of listing the security is responsible for the dissemination of the price changes in that security. Hence, Nasdaq uses the SIP to collect bid/ask and last-price data from all the other trading venues. It disseminates those prices to the rest of the market.

Unfortunately, Aug. 22 was a different day. According to Nasdaq, an exchange participant—supposedly another trading venue—had issues early that morning.


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