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U.S. regulators are preparing to clamp down on firms that send so-called rogue orders into the stock market, citing concerns that an erroneous trade could ricochet across exchanges and ensnare investors.
Such trades are usually caused by data-input errors, and their frequency has fallen in recent years as markets have adopted more computer-driven strategies and exchanges have increased surveillance efforts to stamp them out.
However, electronic trading's split-second pace and increasingly interconnected nature has spurred regulators to take a closer look at the potential spillover effect of stock orders submitted far from the prevailing market price.
A major concern is the impact of a big error in an automated strategy set up to buy and sell component shares of a benchmark index such as the Standard & Poor's 500, which authorities fear could influence other electronic traders' strategies and erupt into a market-moving event.
"It could take on a life of its own," said Thomas Gira, executive vice president of market regulation for the Financial Industry Regulatory Authority, or Finra.
"The velocity of the market has picked up," said Gira in an interview. "When trading was slower, people still made mistakes, but now there's potential for a programming error or computing issue to spit out quotes in a rapid-fire manner and give rise to [problematic] situations."
Getting caught on the other side of a trade that is deemed in error and cancelled by exchange officials can also be a headache for individual investors, who may have jumped at a price that appeared a good deal, or used proceeds from such a trade to buy other stocks.
Exchange operators deem transactions entered at prices wildly off the going market rate to be "clearly erroneous" and eligible to be voided upon request, and regulators in the past have occasionally sanctioned traders for such mistakes.
Finra is now weighing tougher measures including enforcement actions as officials examine 20 to 30 cases of erroneous trades executed in recent months, deploying new rules passed last summer by the Securities and Exchange Commission that require tighter credit and risk controls over traders' activity. Gira said Finra is watching out for serial or egregious offenders.
Following the May 2010 "flash crash," when investors protested after exchanges cancelled thousands of trades, U.S. stock market operators drew up new market-wide standards for when transactions should be voided, which helped bring down the number of errors. The introduction last year of rules governing the way traders gain access to domestic stock markets are expected to further reduce mistakes.
"It's in everybody's best interest for these things to be minimized," said David D'Amico, head of operations for Direct Edge, which runs two electronic stock exchanges. He said his markets now see fewer than 10 erroneous trading episodes per month.
But regulations set up to ensure investors receive the most competitive prices on share trades have increased the potential for trade errors to reverberate across multiple markets. About two-thirds of mistaken trades involve orders that are carried out on more than one stock exchange, with the firm placing the order sometimes not knowing where all of its business was transacted.
The high speed of electronic trading combined with strategies set up to react to minute price movements and the incorporation of leveraged securities like exchange-traded funds carries further potential to magnify mistakes, said Bernard McSherry, a senior vice president with brokerage firm Cuttone & Co. and an assistant professor of finance at New Jersey City University.
"The market has put in place these self-reinforcing loops that can amplify errors and create new problems," said McSherry, who started as a stock broker in the 1970s. "Both people and machines are not infallible, but the question is how you design protections."
-By Jacob Bunge, Dow Jones Newswires; 312 750 4117; firstname.lastname@example.org