The glitch in a Chinese brokerage trading system that sparked a dramatic swing in Shanghai’s stock market last week exposed the flaws and fragility of the country’s nascent capital market and dealt a fresh blow to its long-suffering investors.
Design flaws in a trading system at Everbright Securities Co, China’s ninth-largest broker, caused serial errors that triggered a deluge of buy orders, resulting in a sudden surge in Shanghai shares last Friday morning.
The Shanghai Composite Index, which had been in the negative territory, leapt 5.9 percent in two minutes but later ended the day back in the red.
It was the wildest aberration in Shanghai’s market in four years. The China Securities Regulatory Commission went so far as to describe it as “the first incident of its kind since the birth of China’s capital market.”
Although the top regulatory body said no human operational error has been found in a preliminary investigation of the incident, it would be all too easy — and wrong-headed — to make machinery malfunction the only whipping boy.
Flaws with the brokerage’s risk-control system and the absence of a trading oversight function in the stock exchange contributed to the mishap.
In a Sunday statement, Everbright said flaws in the order-generating system in its proprietary business unexpectedly placed 26,082 buy orders in two seconds, while a failure in its order-execution system sent the orders directly to the Shanghai Stock Exchange.
The erroneous orders totaled 23.4 billion yuan (US$3.8 billion), and the actual transactions involved 7.27 billion yuan.
It is somewhat incredible to contemplate that such a spate of orders, whose value equaled 27 percent of Everbright’s assets on hand at the end of March, managed to escape all the risk-control gatekeepers, such as order limits, duplicate order checks, order routing controls and even the broker’s trade granting mechanism.
Chinese brokerages have been turning to innovative business models to boost profits as their more traditional lines of business have taken a hit from the sluggish stock market and the continued suspension of initial public offerings.
Some industry insiders said many brokerages have sacrificed risk controls in their pursuit of more innovative trading.
Gao Shanwen, chief economist with Essence Securities, said risk controls exist in name only at some brokerages and it is common for investment houses to set lower risk-control requirements for departments that make the highest profits.
Everbright’s problems were compounded on Monday when an input error resulted in 10-year government bonds being sold at a below-market price.
These trading glitches also highlight the absence of an oversight mechanism or any other red-light warning system at the Shanghai Stock Exchange.
Many investors found it hard to fathom how such massive errors, transacted so smoothly, could send 71 Shanghai-listed shares rocketing up to their daily trading limit of 10 percent. Stocks affected included shares in PetroChina Co and Industrial & Commercial Bank of China, the country’s two largest companies by capitalization.
There are indeed lessons to be learned.
In 2009, the Securities and Exchange Commission in the US unveiled an exchange rule designed to stop erroneous trades from being executed.
The rule allows an exchange to break trading if the price of a transaction differs from the consolidated last sale price by more than a specified percentage.
During regular market hours, that means a limit of 10 percent for stocks priced under US$25, 5 percent for stocks priced between US$25 and US$50, and 3 percent for stocks priced over US$50.
Moreover, the review process for the erroneous trades must begin within 30 minutes and must be resolved within 30 minutes after that.
In Shanghai, the trading breach was followed by silence, leaving market players dumbfounded.
The stock exchange finally released a statement 40 minutes after the mad rally, saying its trading system was operating normally. There was no explanation for the sudden surge in prices.
Instead of making a disclosure to the public immediately, Everbright went on to sell 1.85 billion yuan of shares through exchange-traded funds and opened 7,130 lots of short positions in the stock-index future market, in an attempt to hedge risk and minimize its losses from the mistaken trades, the broker said.
During the mid-day trading break, a senior executive of Everbright even denied that a “fat-finger trade” had occurred.
It wasn’t until 14:22pm, hours after the breach, that Everbright announced a problem had occurred related to its independent arbitrage system.
“Nobody knew what had happened, and there were many irrational buys following the blunder trade, amid speculation that the government was supporting share prices,” said Zhang Qi, an analyst with Haitong Securities.
Two-thirds of trading on the Shanghai exchange involves individual retail investors, many of whom have been badly burned by the poor performance of stocks in the past year or so. The latest incident won’t do much to restore their confidence.
“I bought some blue-chip shares following the surge in the big banks because I thought the price rises were a positive signal,” said Li Jin, a veteran retail investor who lost money after most affected shares pared their gains later in the day.
In order to win back investors frustrated by one of the world’s worst-performing market, China’s securities regulator has unveiled a slew of measures since last year, including severe penalties for market irregularities, stricter IPO rules and a nine-month moratorium of new share offerings.
However, trust and credibility are built slowly and can be destroyed almost instantly.
The Everbright saga reminds us just how easily the A-share market can be manipulated by a single institutional investor, adding to existing concerns about inflated prices, underperforming earnings, rampant speculation and false disclosures.
“The Everbright case proves once again that the stock market is not a good place for individual investors but rather a gambling den for institutions,” said Li.