Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

SEC formalizes bail out of fat fingers

Exchanges world wide have often bailed out fat fingered traders who
punch in wrong buy or sell orders. I have blogged about this here,
and also about a rare contrary example here
and here. Such
bail outs create a moral hazard problem because traders have
insufficient incentives to install internal controls and processes to
prevent erroneous orders.

Instead of stopping this practice, the SEC has now stepped in
to formalize the moral hazard and has also set exceptionally low
thresholds for such bail outs:

In general, the new rules allow an exchange to consider breaking a
trade only if the price exceeds the consolidated last sale price by
more than a specified percentage amount: 10% for stocks priced under
$25; 5% for stocks priced between $25 and $50; and 3% for stocks
priced over $50.

I believe this move by the SEC reflects regulatory capture: those
who are harmed by trade cancellation are typically day traders and
other small traders who have little voice in the regulatory system,
while those benefited by the bail out tend to be large trading
firms. (The very term day trading is always used pejoratively –
when a large firm does it, the terminology changes to high frequency
trading which suddenly sounds a lot more respectable).

Three years ago, I wrote:
“Clearly exchanges can not be trusted with the discretion that
is vested in them. The rule should be very simple. Traders should bear
the responsibility (and the losses) of their erroneous trades.”
I wonder now whether the regulators can be trusted with the discretion
that is vested in them.

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