Compliance Lessons from the Recent “Trading Glitches”

Over the past two years we have seen some rather egregious trading errors take place. Knight Capital,
J.P. Morgan, Goldman Sachs, and most recently, NASDAQ, have all had their share of spectacular trade related faux pas. As the markets continue to shift towards greater dependency on technology for speed of execution, it is the quality of execution that suffers most when a trading error occurs. Recent history should show us that trade errors should not be taken lightly. Knight Capital was sold as a result of its
$450 million error. J.P. Morgan will be paying the price for its London whale episode for years to come via the legal fallout. The situation with NASDAQ is still unfolding, but it is a prime example of how a weak disaster recovery plan can leave a firm (in this case an entire exchange) severely exposed.

Last Thursday, the quotation system for NASDAQ listed stocks (SIP) failed. As a result, no exchange could trade any NASDAQ listed security because there was simply no bid or ask price available. This one, rather important system (SIP), suffered some sort of technological failure and the system had no backup. It seems rather unbelievable that a system as important as SIP had no backup, but apparently creating a second redundant system had been explored by the exchanges in the past and voted against due to the expense of creating it. They may be reconsidering that decision now…

Anyone in compliance knows that trading problems are called “trade errors” in our lingo. A good compliance program includes a plan for dealing with trade errors. Compliance personnel should be brought into the process very early and as soon as an error is discovered. However, as consultants we often see this is not the case. Most trade errors are initially treated as operational issues and compliance is often only brought in when client harm is involved or if the error is over a certain amount. This may work well for some firms, but only where compliance is conducting strong trading surveillance and has access to ALL trade error information over time.

The SEC often requests information on trade errors during examinations of firms. For a firm with large trading volumes, trade errors are actually expected by the regulators. They understand trading happens quickly and as a result mistakes may happen. However, from a regulators perspective, the way the trade errors are handled by a firm is the key.

The fact that trade errors are now making headlines, disrupting markets and trading activities, and even bringing down firms shows that this is a growing area of weakness in our industry. Trade errors are often not handled appropriately. We encourage you to take a look at your trade error policies and ask yourself these questions:

  • Do you have a written trade error policy?
  • How has the policy been communicated to trading staff?
  • Do you maintain a trade error log and is it being utilized?
  • At what point is compliance notified of an error?
  • Could compliance uncover an error on its own without being notified?
  • What is the escalation process for trade errors?
  • How is your trading process included in your disaster recovery plan?
  • Do you have the appropriate level of redundancy for your electronic trading systems?
  • For proprietary trading models, how are these models evaluated and tested for accuracy over time?

These are important areas of consideration when developing an effective trade error plan. Next week the CFTC expects to release a new report on automated trading systems. It will be interesting to see if the report addresses trade errors directly.