By John McCrank
NEW YORK (Reuters) - A year after Goldman Sachs (GS.N) bungled a software upgrade and lost tens of millions of dollars from unintended trades, the 12 U.S. stock options exchanges have crafted new rules for dealing with erroneous transactions, according to draft documents seen by Reuters.
Under the proposed rules, unintended trades placed by professional traders will usually have their prices adjusted to levels as close to their fair market value as possible, while wrong trades by retail customers will be mainly be undone, five sources with knowledge of the matter told Reuters.
The rules are meant to protect investors from algorithms gone wild and other sources of market turmoil. Regulators and exchange operators across equities, commodities and other markets have been taking steps to prevent mistaken trades from spiraling into collapses, a rising concern as trading grows increasingly automated.
When market prices are oscillating wildly, technical glitches can create turmoil, said Andy Nybo, head of derivatives research at advisory firm TABB Group.
"A cohesive solution for the industry is critical to get in place before we have another technology blowup," he said.
In other markets, technical glitches have created big trouble for traders. Knight Capital Group, a stock trading firm now known as KCG Holdings Inc, lost $461.1 million in August 2012 from new software that was improperly installed. The loss forced the company to seek $400 million of rescue capital and eventually led to its sale to a rival firm.
But critics say the new stock-option trading rules are hardly perfect. Participants often don't know whether they are trading with a professional or a retail investor. If markets start surging or plunging unexpectedly, traders have no way of knowing if their positions will disappear, or be adjusted.
That uncertainty could result in many traders exiting a choppy market just when they are most needed, said Thomas Peterffy, founder and head of Interactive Brokers (IBKR.O), a brokerage and options market maker.
"All of the liquidity goes out of the marketplace and then it will never recover," he said. Although listed stock options markets are a fraction of the size of U.S. equities market, derivatives exchanges are seen as a crucial tool for dealers and other market participants to offload risk from the stock market.
The proposed rules come at the behest of U.S. Securities and Exchange Commission Chairwoman Mary Jo White, who last September ordered the heads of the exchanges to take specific steps to make the cash equities and options markets more sound, including a unified rule for obvious errors for options trades.
Exchanges have been fine-tuning the plan with the help of the SEC since June, and expect to file it with the regulator in four to six weeks, according to one of the people. All of the sources asked to remain anonymous because the details are not yet public.
Once the plan is filed with the SEC, it will be made available for public comment, which will later be reviewed by the regulator before deciding on whether to approve the rule.
Options exchange operators NYSE, which is owned by Intercontinental Exchange Inc (ICE.N), Nasdaq OMX Group (NDAQ.O), BATS Global Markets, CBOE Holdings (CBOE.O), International Securities Exchange, owned by Deutsche Boerse (DB1Gn.DE), and BOX Options Exchange, owned by TMX Group (X.TO), declined to comment for this story, as did the SEC. Miami International Holdings Inc did not respond to a request for comment.
ONE PROBLEM, A DOZEN SETS OF RULES
Options trade across a dozen different exchanges, and each exchange has its own rules for how to deal with mistaken trades.
Those differing rules can create trouble. In August 2013, Goldman's software snafu resulted in its flooding stock options markets with bad trades, pushing the prices of some options down sharply.
When Goldman Sachs said the transactions were erroneous, some exchanges canceled the positions, and some did not. Traders that had bought an option from Goldman on one exchange and sold the same position on another could have found themselves holding an option they thought they had sold. Goldman's losses would have been far greater had most of the trades not been canceled.
In crafting rules for dealing with mistaken trades, exchanges had originally planned to adjust most obviously erroneous trades, said three people familiar with the matter. But retail brokers objected, and said that their customers tend to make mistakes that professionals don't, such as buying or selling a completely different option from what they had intended to trade.
Allowing different treatment for professional traders versus retail investors seemed like a middle ground, the sources said. Retail trading accounted for 24.3 percent of options market volume in the first half, according to TABB Group.
Under the rules, a trade is deemed obviously erroneous if its price differs dramatically from the market level for that option soon before and after the transaction was executed. But the rules also allow market participants to change trades that were harmed by unexpected market movements that had nothing to do with technical glitches: a trade can be deemed obviously mistaken even if the price movement that triggered the trade was just a market gyration after a surprising event.
After the proposed rules are in place, the exchanges will then consider a second phase of coordination, including appointing a single, uniform source for determining the theoretical prices of options, something that each of the exchanges now does on its own, three of the sources said. The exchanges will also look at implementing a system similar to one in the stock markets where options would be prevented from trading outside a range based on recent prices, the people said.
The exchanges have given themselves leeway in the rules that would allow them to cancel all erroneous trades for all participants if they think that doing so would lead to getting the market back to a normal state as quickly as possible.
(Reporting by John McCrank; Editing by Dan Wilchins and John Pickering)