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.


According to VentureBeat sources, the “exchange participant” rebooted its system several times—and by several, they mean more than 30 times.

This created a backlog of data from the participant that eventually flooded the Nasdaq SIP when the exchange participant finally got its system back online. As a result, the SIP was paralyzed from the overload, and because prices for Nasdaq-listed securities couldn’t be disseminated, the shutdown occurred.

There are a number of issues that we need to focus on here.

I appreciate Nasdaq’s willingness to take responsibility for the three-hour halt, but I’d be lying if I said I was satisfied.

If one of the culprits of this meltdown was truly an exchange participant, then that party needs to be revealed and should also take responsibility.

Secondly, the processing capability of the SIP is something of concern. I don’t consider myself anything close to a hacker, but the SIP’s recent overload is awfully reminiscent of a denial-of-service attack (DoS).

For those that don’t know, a DoS attack is an attempt to make a machine or network resource unavailable to its users. It’s usually done by saturating the target machine or server with external communication requests—so many that the server can’t respond to legitimate requests.

I’m not one to speculate as to whether Nasdaq was hacked, but the nature of the SIP’s shutdown does bother me. It’s not that far-fetched to imagine a scenario where someone could shut down the exchange again by means of overloading the SIP with data from another trading venue.

Frankly, I don’t believe the SIP should be managed by Nasdaq. Rather, regulators should manage and reinforce the SIP. Especially in a day and age where investors are increasingly concerned about who has access to such data and when they receive said data relative to the rest of the market. The fact of the matter is the system is outdated.

The worst aspect of this recent meltdown is that market structure failed where it should have excelled. It was once thought that competition among exchanges would give investors options and the ability to access liquidity however they pleased.

However, this recent episode has taught us that this is far from the truth—no one could trade the PowerShares QQQ Trust (QQQ | A-59), the Nasdaq 100 ETF, or any other Nasdaq-listed ETF, on an alternative venue.

That’s just unacceptable, and hopefully, this serves as a wake-up call.

At the time of this writing, the author held no positions in the securities mentions. Contact Ugo Egbunike at [email protected]. Follow him on his Twitter handle at @UgoEgbunike.


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