Opinion and Investing Column

SKARBECK: Exchange's bizarre IPO triggers securities probe

April 7, 2012

Ken Skarbeck InvestingSecurities regulators are looking into several issues raised in the aftermath of the failed initial public offering of BATS Global Markets on March 23.

Better Alternative Trading System is a 7-year-old stock exchange that has become the third-largest exchange behind NASDAQ OMX and NYSE Euronext. A 2007 regulatory change requiring stock trades to be routed to the exchange with the best price spawned more than 50 new trading platforms. BATS has grown to become a competitive alternative to the larger exchanges mainly by catering to high-frequency trading firms.

The bizarre events surrounding the IPO began with the company’s shares priced at $16 on March 23, raising $100 million for the firm. Shortly after BATS stock began trading, the company’s trading system malfunctioned for securities with ticker symbols between A and BF, causing trading errors in several stocks, including Apple Inc. Specifically, the BATS system completed a trade in Apple stock at $542.80 per share—sharply below the actual market price of almost $600. That trading error tripped the circuit breaker on Apple’s stock and briefly halted trading of the company’s shares.

The Securities and Exchange Commission established circuit breakers on all stocks following the “Flash Crash” of May 6, 2010. On that day, the Dow Jones industrial average plunged 700 points in a matter of minutes as a result of technical glitches in the market’s trading systems. The glitches were the result of certain kinds of stock orders used by high-frequency traders. The resulting circuit-breaker rule requires a five-minute trading halt any time a stock rises or falls more than 10 percent in five minutes.

Of course, the embarrassing irony is that, on the very day BATS itself became a publicly traded company—one in the business of stock trading, no less—its trading system encountered major errors. BATS halted trading in its own stock and then took the unusual step of pulling its IPO off the market all in the same day.

BATS was founded by Dave Cummings, a Kansas City native and Purdue University graduate. A former high-frequency trader, Cummings founded BATS as an exchange geared to attract high-frequency firms and grew its business by charging lower fees than the NASDAQ or NYSE. BATS now handles about 11 percent of the daily trading volume in U.S. equities.

The bigger issue facing BATS and the other nascent exchanges is the SEC’s investigation into high-frequency trading. The agency is examining the complex relationships—including ownership ties—between the rapid-fire trading firms and stock exchanges to determine whether such firms have an unfair advantage over other investors.

Among the practices the SEC is probing: a type of high-frequency order called a “Hide Not Slide” that essentially disguises the order from the market and may allow these trades to jump ahead of other investors’ buy or sell orders. Regulators also are scrutinizing the rebates exchanges pay to some high-frequency firms for their business—in contrast to the fees most investors pay to complete a trade.

With the explosion in both exchanges and high-frequency traders, the SEC has a Herculean task, for, as one observer commented, “we’ve managed over the past few years to equip the traders with Ferraris and the regulators are trying to keep up with them on bicycles.”•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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