The Everbright Securities Co. trading error that caused a temporary spike in the Shanghai stock market last month has raised concerns that the incident may worsen the reputation of China’s beleaguered brokerage industry and prompt regulatory brakes on innovation in the sector. But some analysts see the trading glitch as a catalyst for positive change.

A malfunction in Everbright's proprietary-trading system on August 16 trigged a deluge of orders that caused wild fluctuations in share prices. The benchmark stock composite index shot up 5.9 percent in two minutes, before giving up gains.

China Securities Regulatory Commission, the top securities regulator, fined Everbright a record 523.3 million yuan (US$85 million) and banned four executives from working in the industry for life.

The regulator said Everbright violated a number of legal and regulatory rules, including insider trading after the firm rushed to take huge short positions in index futures and exchange-traded funds to hedge its own losses before disclosing the trading glitch to the public.

The CSRC barred Everbright from further proprietary business, or trading on its own account, without specifying when the ban will be lifted. It also suspended approval of any new business for the brokerage.

Everbright’s disgrace came at an unfortunate time for the brokerage industry. Firms in the sector have been turning to more innovative products to boost profit as traditional lines of business suffer from the persistent downturn in the stock market and a moratorium on initial public offerings continues.

According to report by Guangfa Securities, the combined revenue from investment banking business at China’s 19 listed brokerages plunged 43 percent in the first six months of 2013 due to a freeze in the IPO market since last year.

Meanwhile, income from trading commissions, once the primary source of revenue at securities firms, accounted for only 39 percent of total earnings at listed brokerages in the first half.

Amid financial reforms and deregulation, innovation has become the catchword for earnings growth.

Since last year, China’s securities regulator has introduced an array of measures to reduce restrictions on market trading and expand the business scope for the sector.

In May, for example, the CSRC lifted a ban on brokerages issuing short-term financing bills in the interbank market. Rules have also been drafted to encourage bond issues, develop the repurchase market and raise the ceiling on the leverage ratio for brokerages, enabling them to

borrow money to fund new businesses.

The watchdog has also allowed brokerages to expand margin trading and short selling businesses, and given the green light for them to market mutual funds.

Data from Orient Securities show the aggregate balance of margin-trading and short-selling accounts at listed brokerages at the end of June was 109.7 billion yuan, a 134 percent surge from a year earlier. Income from margin trading and short selling totaled 3.4 billion yuan in the first half, accounting for 9 percent of revenue at listed brokerages.

Earnings from mutual fund business posted an average 213 percent increase among listed securities houses in the first six months, thanks to explosive growth in assets under management, according to the Orient.

“Latecomers to new brokerage businesses are expected to become primary sources of revenue in the industry because the decline in trading commissions is an inevitable trend due to fierce competition,” said Wang Mingfei, an analyst with Orient. “However, the development of new types of business is very much dependent on support from regulators.

Some industry watchers said they are concerned that Everbright’s trading mishap might cause regulators to pause in their promotion of brokerage innovation.

“The trading error by Everbright, which stands at the forefront in terms of business innovation, exposed system flaws and risk-control issues embedded in the brokerage industry,” said Zhang Lei, analyst with Tebon Securities, “The mishap may trigger tighter regulation on the sector and slow the pace of business innovation.”

In the Everbright case, flaws in the order-generating system unexpectedly placed 26,082 “buy” orders in two seconds, while a failure in its order-execution system sent the orders directly to the stock exchange.

The erroneous orders totaled 7.27 billion yuan, or 27 percent of Everbright’s assets on hand at the end of March. Many are still wondering how the glitch 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.

That may be only the tip of an iceberg. Some industry insiders said many brokerages tend to compromise risk control for efficiency in making innovative trades.

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 making higher profits.

Li Cong, an analyst with Guangfa, said the regulator is likely to impose stricter supervision over

the approval for new businesses after the trading glitch and that may weigh on the valuation of listed brokerage shares in the short term.

Shares of Everbright have slumped 32 percent since the trading glitch and nearly 10 billion yuan has been wiped out from the brokerage’s market capitalization.

However, some see a silver lining in the cloud overhanging the industry. They say the trading glitch may be a reality check for an industry that has been running too hard and too fast, without heeding risks.

“The Everbright incident is a warning to the brokerage industry and will prompt securities firms to be cautious in their business dealings and strengthen their risk-control mechanisms,” said Zhang Qi, an analyst with Haitong Securities.

“Trading glitches sometimes play a positive role in the development of capital markets,” said Wei Tao, an analyst with China Securities Co.

He cites the incident of the sudden 998-point freefall in the Dow Jones Average in May 2010 – the so-called “fat finger” mistake -- that prompted the US Securities and Exchange Commission to strengthen circuit breakers and improve procedures for handling erroneous trades.

The Shanghai Stock Exchange, which failed to stop the deluge of erroneous orders sent from Everbright, said it is considering introducing a circuit-breaking system to avoid a repeat of the mishap.

The exchange also said it will step up research into the possibility of introducing a T+0 trading mechanism to better protect the interests of small investors. That refers to the ability to complete a stock transaction on the same day it was made, including settlement, payment and transfer of ownership.

China currently adopts has a T+1 mechanism, which means investors cannot sell a stock the same day they bought it, but rather have to wait until the next trading day.

During the Everbright fiasco, many investors who brought shares following the sudden surge in prices suffered losses because they were not able to correct their missteps quickly.

“The Everbright incident is unlikely to snap the innovative development of the brokerage sector,” Wei said, “Instead, it might be a blessing in disguise for the market as long as regulators take actions to address the flaws.”