Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Tokyo Stock Exchange Trading System: Why Not Open Source?

The Financial Times reports that “The Tokyo Stock Exchange is considering
replacing its trading system, even though it is merely a year old, following
computer problems that have shattered the exchange’s reputation and
damaged Tokyo’s status as a financial centre.”

Clearly the Mizuho trading error that I blogged about
last month
has been the main driving force behind this move. I would argue that open source is the
better way to go if the goal is to make the trading system more robust.

I have been reading the

official explanation
that the Tokyo Stock Exchange (TSE) put out on the Mizuho incident.
As I understand it the sequence of events was as follows.

  • At the beginning of the first day of listing of J-COM (December 8, 2005),
    a special bid quote of
    672,000 yen was being displayed in order to determine the initial listing price.
    Special quotes are used at the TSE during the call auction (Itayose method)
    that is used to determine the initial listing price of stocks that have never
    been traded before at the TSE or at any other exchange. The

    Guide to TSE Trading Methodology
    gives the details of this process.
  • At 9:27 am while this special quote was being displayed, Mizuho mistakenly
    placed a sell order for 610,000 shares of J-COM at 1 yen, instead of the intended
    1 share at 610,000 yen.
  • The Mizuho order allowed the conditions for execution of the special bid quote
    to be fulfilled and the trade was completed. The call auction (Itayose method)
    requires that all market orders as well as all orders on one of the two sides of the
    order book should be executed and that the volume executed should be a minimum of
    1000 trading units. The Mizuho order was large enough to meet all these conditions.
  • This trade established the inital listing price of 672,000 yen as also
    the lower price limit for the day of 572,000 yen. The Tokyo Stock Exchange
    has computed
    that in the absence of the Mizuho order, a price of 912,000 yen per share
    would have prevailed.
  • The remaining part of the Mizuho order was now deemed to be an order at the
    lower limit price of 572,000 yen (“deemed processing”) and started
    executing against various buy orders.
  • “Meanwhile, Mizuho Sec. made several attempts to cancel the order, but as
    these cancel orders were made while executions were being processed, an
    irregularity occurred in which the target order was not canceled. This is an
    irregularity that arises when deemed processing is applied to an order, and
    a corresponding opposing order exists.”

Summing up the nature of the problem, the Tokyo Stock Exchange states:

“This is an incident that occurs when an issue is newly listed on the TSE
directly and, as in this case, while a special bid quote is displayed, such
a large amount of orders is placed that the net amount exceeds the number of
the special quote order, and many sell orders still remain after the initial
price is determined, to which deemed processing is then applied and then
orders are placed at that price. As such, we are committed to strengthening
supervision of newly listed issues in the near future and conduct extensive,
detailed investigations of our system while considering the possibility of
this and all other cases in the future, in ensuring irregularities such as
this do not occur again. Also, the TSE will conduct a prompt, thorough
analysis of the details of the cause of this recent irregularity in
cooperation with the trading system developer, Fujitsu, Ltd.”

It appears that the irregularity that was observed would have occured only
under very special circumstances that may never be repeated in future. It is also
evident that in a complex trading system, the number of eventualities to be
considered while testing the trading software is quite large. It is very likely
that even a reasonable testing effort might not detect all bugs in the system.

Given the large externalities involved in bugs in such core systems, a better
approach is needed. The open source model provides such an alternative. By exposing
the source code to a large number of people, the chances of discovering any bugs increase
significantly. Since there are many software developers building software that interacts
with the exchange software, there would be a large developer community with the
skill, incentive and knowledge required to analyse the trading software and verify
its integrity. In my view, regulators and self regulatory organizations have not
yet understood the full power of the open source methodology in furthering the key
regulatory goals of market integrity.

Also, there is a case for simplifying the trading system. The trading system at TSE
is unnecessarily complex because of the existence of price limits and the complex
combination of call auction (Itayose method) and continuous auction
(Zaraba method). TSE needs to question the very need for special quotes.


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