Advice to Nasdaq and the NYSE: Cancel Only 90% of the “Erroneous” Trades

Nasdaq and the New York Stock Exchange have both announced that they will cancel many trades made during the temporary market meltdown between 2:40 and 3:00 last Thursday afternoon (see, for example, this story from Reuters). These “erroneous” trades include any that were executed at a price more than 60% away from their last trade as of 2:40.

The motivation for these cancellations is clear: a sudden absence of liquidity meant that many stocks (and exchange-traded funds) temporarily traded at anomalous prices that no rational investor would have accepted.

As several analysts have noted, however, canceling these trades creates perverse incentives. It rewards the careless and stupid, while penalizing the careful and smart. It protects market participants who naively expected that deep liquidity would always be there for them, while eliminating any benefits for the market participants who actually were willing to provide that liquidity in the midst of the turmoil.

Kid Dynamite has helpfully linked to several comments along these lines, as well as providing his own view:

Paul Kedrosky asks aloud: “why are we wiping out all the errant trades by runaway algorithms and market battle bots?”

David Merkel points out, emphasis mine: “NASDAQ should not have canceled the trades.  It ruins the incentives of market actors during a panic.  Set your programs so that they don’t so stupid things.  Don’t give them the idea that if they do something really stupid, there will be a do-over.”

And the Law of Unintended Consequences rears its ugly head again.  Merkel’s point is simple and accurate:  if buyers who step in later see their trades canceled, it removes all incentive for them to step in – and then you don’t get the bounce back that we saw!  Think about how much havoc it causes a trader who astutely bought cheap stock, then sold it out at a profit.  He’s now short!  Or, he spent the entire day wondering if his order would be canceled, in a state of limbo.  What’s the alternative – that traders should just assume that the orders will get canceled, and NOT buy stock?  Guess what – if no one buys, the stock stays cheap! SOMEONE has to buy, and that someone shouldn’t be penalized in favor of remedying the ignorance of the seller who screwed up.

I see merit in both sides of this argument. My economist side thinks people should be responsible for their actions and bear the costs and benefits accordingly. But my, er, human side sees merit in protecting people from trades that seem obviously erroneous.

What’s needed is a compromise–one that maintains good incentives for stock buyers and sellers, but provides protection against truly perverse outcomes.

Happily, the world of insurance has already taught us how to design such compromises: what we need is coinsurance. People have to have some skin in the game, otherwise they become too cavalier about costs and risks. That’s why your health insurance has co-pays and coinsurance. Those payments undermine the risk reduction that insurance provides, but for a very good reason; 100% insurance would make medical care free, and people act really weird when things are free. Even a little skin in the game gets people to pay attention to what they are doing.

So here is my proposal:  NYSE and Nasdaq should cancel only 90% of each erroneous trade. The other 10% should still stand.

If Jack the Algorithmic Trader sold 100,000 shares of Accenture for $1.00 last Thursday, he should be allowed to cancel 90,000 shares of that order. But the other 10,000 shares should stand–as a reminder to Jack (and his boss) of his error and as a reward to Jill the Better Algorithmic Trader who was willing to buy stocks in the midst of the confusion.

4 thoughts on “Advice to Nasdaq and the NYSE: Cancel Only 90% of the “Erroneous” Trades”

  1. I’m almost 100% certain that some quick traders profited by the volatility–even with the cancelled trades.

    However, the idea of letting the abnormal trades stand is a bad one. First, the stock market does a good job of punishing the stupid and rewarding the smart. It sometimes rewards the lucky too.

    But the problem Thursday was one of process and execution. It was more akin to the Staten Island ferry running into the dock. One doesn’t punish the passengers who didn’t know to grap hold of something because they didn’t realize the ferry was malfunctioning.

    This isn’t a “perverse incentive” problem regarding the trade outliers, in other words. There are perverse incentives in the markets that can be rectified, but they are not reflected in any important way by the 100 or so trades that were unwound.

  2. investing in stock, meant buy low sell high or versa with minimal rist, that’s the game. so i did buy ipxl at $1 and sold at $10 within a minute, made my money and closed all my position. now next day, my buy order got cancelled because no errors found issue and my sold order become short sell and it’s now $18. so instead making money now i am short and profit made was cancelled out, Net Negative $8K since my buy did not exist. tell me this is fair. if my buy got cancelled, then they should cancel my sell as well. this is just like killing innocent people without using gun.

  3. I was one that got hosed that day by a QQQ stock option. Went to sell my 20 PUT options during the down swing at the market. Bid was at .65 and rising and somehow it sells at .01. Then right after mine sells for .01 another sells back at the .65 range. So having a 1 second spike is just the market? I don’t think so. I’ve never seen such an event in the 20 years I’ve been trading.

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