Electronic trading may be the wave of the future, but Friday's fiasco involving shares of
raises questions about ECNs' alleged superiority to the
New York Stock Exchange's
human-based specialist system. The episode also calls into question the wisdom of having decentralized marketplaces under various regulators.
In the wake of scandals early this year at the NYSE over ousted chairman Richard Grasso's pay package and the alleged front-running of customers by some specialists, the Big Board's system has come under fire for being antiquated at best, ripe with corruption at worst.
But advocates of the specialist system say the Corinthian Colleges' episode demonstrates why having a human element is critical despite the electronic communication networks' advantages of speed, anonymity and, potentially, price.
"You lose something by going all electronic," said Terry Hendershott, a professor at the University of California at Berkeley's Haas School of Business.
Although a believer in electronic trading, Hendershott said human-based markets are often superior to electronic ones when extraordinary events occur and the market is under stress.
Case in point being last Friday, when the
Nasdaq Stock Market
halted trading in Corinthian Colleges for nearly an hour after mistakenly placed sell orders caused a 32% swoon in the shares of the secondary-education provider in a mere 12 minutes.
Judging there to be no news event to justify the trading halt -- the Nasdaq's original rationale -- Archipelago, an electronic marketplace owned by a consortium of major Wall Street firms, resumed trading in Corinthian Colleges more than 30 minutes before the Nasdaq lifted its halt.
Archipelago's decision meant that while some investors were unable to trade Corinthian Colleges during Nasdaq's trading ban, others were buying and selling shares via Archipelago at what were arguably artificially low levels. That became crucial when the Nasdaq later canceled a swath of trades from earlier in the day.
Shares in Corinthian College bounced back to near their previous highs after trading resumed on the Nasdaq, but investors could have been inadvertently caught selling the stock short, i.e., selling shares they believed they had bought earlier in the day via Archipelago, but didn't actually own because those transactions were canceled.
The episode caused tremendous frustration for traders, and revealed a growing rift between the Nasdaq and the Pacific Exchange, Archipelago's regulator.
"The lack of coordination among the markets caused widespread confusion and unnecessarily harmed investors," Edward Knight, the Nasdaq Stock Market's general counsel, admitted in a letter Monday to the
Securities and Exchange Commission
. "We must take immediate, decisive steps to protect investors from the reoccurrence of trading dysfunctions such as occurred on Friday."
Nasdaq's solution is for the SEC to give it the power to halt trading on all exchanges in over-the-counter stocks due to irregular trading on any one of those marketplaces.
But "that's wholly inappropriate and blatantly anticompetitive," said Dale Carlson, a spokesman for the Pacific Stock Exchange. "The fact they had a systems problem -- 'I'm sorry I hope you get it fixed quickly' -- everyone else shouldn't have to stand around twiddling their thumbs and leave investors hanging."
Nasdaq tried to get all exchanges to stop trading Corinthian shares by mischaracterizing a system problem as a regulatory one, Carlson said. The Pacific Stock Exchange -- which complained that the Nasdaq had no legitimate reason to halt the shares -- wants the halt probed.
People Who Need People
Regardless of how the dispute between Nasdaq and Archipelago is resolved, the incident points out some of the problems with electronic trading. Most obvious is the decentralized nature of Nasdaq trading.
"Under the guise of promoting competition, a lot of things have been done to destroy the central marketplace," said Mike Epstein, a former NYSE member and a visiting scholar at the Sloan School of Management at the Massachusetts Institute of Technology. "These kinds of things will happen
maybe not more often, but not less often."
Had Corinthian Colleges been an NYSE-listed stock, the specialist for the stock may have alerted regulatory officials to a potential erroneous trade at the onset, potentially prompting a halt before the swoon, not after (or during). Because specialists have an obligation to use their own capital to maintain so-called orderly markets in their stocks, they are more sensitive to potential disorderly developments than faceless electronic marketplaces.
If the NYSE calls a trading halt on a stock, trading is effectively stopped because electronic alternatives to the system aren't widely used by institutions. Meanwhile, under NYSE rules, if any trades occur after trading is officially halted, the responsibility for reversing those trades and making investors whole is up to the specialists.
But on the Nasdaq, trades are handled by numerous electronic exchanges, including not only Archipelago, but also the Island and Brut ECNs. Archipelago says that on any given day, about 27% of the trading volume in Nasdaq stocks is done through its systems.
The advantage of a decentralized system is that much like the Internet, it can route around problems. When blackouts knocked out markets on the East Coast in August, Nasdaq stocks still could be traded over ECNs. But that decentralization also makes possible situations such as what happened on Friday.
The decentralization issue is compounded by the fact that Archipelago answers to a different regulator than other ECNs.
"This is something on
SEC Chairman William Donaldson's plate to figure out," said Seth Merrin, CEO of Liquidnet, an electronic exchange designed for institutional investors.
Given that Donaldson already has a pretty full plate, some observers say the quick and easy answer is that a trading halt should apply to all markets no matter what the reason.
"If everybody can't trade, then no one should trade," whether trading is disrupted because of a regulatory issue or a systems issue, Epstein said.
But others question that view. It's a benefit to investors that electronic networks can work around problems such as blackouts, they argue. In addition, shares trade hands every day after hours on electronic marketplaces long after the Nasdaq market closes.