Date: August 20, 2013
Source: Futures Daily

　　August 16, 2013 is doomed to be written in the Chinese securities history. The false operation of a proprietary account of Everbright Securities has 100 times amplified its trading volume of 30 million shares. A total of 71 large-cap blue chips, including Industrial and Commercial Bank of China, China National Petroleum Corporation and Sinopec Group, almost reached the maximum trading limit in an instant. The parties concerned, namely, Everbright Securities and relevant regulatory authorities, have timely released announcements after the incident, confirming that the fat finger was caused by Everbright Securities’ false orders. The Shanghai Stock Exchange (SSE), China Financial Futures Exchange (CFFEX) and China Securities Regulatory Commission (CSRC) have so far already taken emergency remediation measures. The “frightening 3 minutes” on August 16 has passed, but the follow-up measures to deal with the fat finger incident should be well considered and comprehensively arranged. Besides, a series of problems exposed in the incident are worth deep introspection of all personnel in the securities market, including the market regulators.

Causes and nature of the fat finger incident

There are two causes to the occurrence of the fat finger incident and its follow-up impacts, namely, the trigger mechanism of program trading and the chain reaction among institutional investors. As most institutional investors in the market make calculations with the same or almost the same indices, the trigger points are the same on the whole. Everbright Securities fired the first shot and on hearing the shot other institutional investors had not realized that it was an accidental discharge and believed it was a great positive signal of the market. Under the trigger mechanism, the program trading of many institutional investors responded quickly with a large number of follow-up buy orders, thus triggering the butterfly effect and causing the upper limit of trading of over 70 big-cap blue chips. In fact, without the chain reaction caused by the trigger mechanism among non-institutional investors, Everbright Securities alone cannot push more than 70 big-cap blue chips to the trading limit.

Therefore, the key to defining the nature of this incident is whether the order of 30 million shares is deliberately or accidentally made. It is not absurd to regard the fat finger incident as an accident in terms of the event itself, as the same accident has occurred in the U.S. Dow Jones index, in which a trader falsely typed the “million” into the “billion”, causing the fall of the index nearly one thousand points on that day. However, if considered from the result of the incident, it should be reviewed whether the short position of stock index futures was made by Everbright Securities before, during, or after the incident. If it’s beforehand, the incident will be defined as vicious market manipulation; if it’s during the incident, it will be defined as deliberate market manipulation; if it’s afterward, it is definitely a reasonable self-salvation despite the suspicion of getting out of line. First, the fact whether it is before, during, or after the incident should be defined by the information disclosure time. Whether the announcement made by Mei Jian, Secretary to Directorate of Everbright Securities, at noon on that day can represent the official announcement of Everbright Securities still needs further consideration, and whether the incident should be announced in the in-session trading also needs further discussion. Second, the short position of 6,877 contracts of stock index futures held by Everbright Securities that afternoon is within the arbitrage and hedging limit approved by CFFEX. Finally, according to the self-inspection result made by Everbright Securities, its overall mark-to-market loss on that day was RMB194 million and therefore it did not made a great number of profit on the futures market. To sum up, whether judging from the fat finger operation or the final consequence undertaken by Everbright Securities, this incident could be defined as an erroneous order incident.

Aftermath treatment should be rational, justified, and well-planned. Erroneous order is also a market behavior and further punishment should be reasonable and based on facts.

Since it is regarded as an erroneous order, the incident and the mispricing triggered by it should be regarded as the market behavior, and the securities market itself should have fault-tolerant mechanism. From the practical level, compensation for the incident is unrealistic and there’s no such precedent in the international market. It is mainly an incident caused by erroneous order and pricing with victims and consequential losses that cannot be clearly defined and estimated, as the losses of the incident are mostly caused by the market’s chain reaction, typical of the butterfly effect.

On August 18, CSRC released the preliminary inspection of the incident and set up an official investigation. If regulatory authorities would punish Everbright Securities, they should be rational and justified. To be rational means that they should have clear laws and regulations to indentify that the operation has violated laws and rules, but CSRC clearly stated on August 16 that all transactions on that day are valid. However, with regard to the law-breaking operations, such as the “327 treasury bond” incident, all the transactions can be identified as invalid. To be justified means that they should have hard evidence to show that the incident is deliberately manipulated by men, which has not been confirmed up till now. While dealing with the fat finger incident, it should learn a lesson from the “327 treasury bonds” incident so as to avoid hypercorrection. After the “327 treasury bonds” incident, the regulatory authorities have moved the national bond market from the capital market to the monetary market. Besides, the bond market of the securities market has remained dejected while the inter-bank treasury bond market has been prosperously developed.

Of course, Everbright Securities has exposed some major risk-control problems. Therefore, it makes sense to punish Everbright Securities for its ineffective risk control and to investigate the responsibilities of the parties concerned and responsible persons. Meanwhile, part of the fine paid by Everbright Securities can be used to replenish the investor protection fund, which can be regarded as an explanation for investors. However, under the principle of “openness, fairness and justice”, the regulatory authorities should be careful and prudent in evidence collection if they are to make severe punishment to Everbright Securities. Otherwise, the whole incident will affect the impartiality of China’s securities market in the long term.

A careful plan should be made to deal with Everbright Securities’ positions on the stock and futures markets.

In addition, apart from defining the nature of the incident and making the punishment according to the law, how to deal with the positions of Everbright Securities on the stock and futures markets has become the key to coping with the aftermath. At present, its accounts on the futures market have been restricted to open any position and the next step is to deal with its positions on the two markets with a careful plan step by step. Everbright Securities had positions of over RMB7 billion at higher prices. Although about RMB1.8 billion of the positions had been closed out through ETF that afternoon, the remaining amount is still very big. Therefore, in the following trading days, Everbright Securities should be limited to do the one-time short selling on the securities market. Otherwise, it would bring about a second impact to the market. Besides, the stock positions established by false operation can also be gradually digested through such measures as redesigning product portfolios, daily limit for closing out positions, and returning to the primary market to carry out negotiating transfer. The operation on the securities market can also be used to resolve Everbright Securities’ positions on the futures market. The current position can be resolved in accordance with the principle of “symmetrical position-closing”. In addition, Everbright Securities should be banned from taking the rolling hedging measures on the futures market, so as to avoid its doing other mistakes to further impact the futures market.

Reflection on the fat finger incident: market participants and regulators should further improve their risk control mechanisms.

The risk control issue found in the fat finger incident deserves heightened alertness from market participants and regulators as well. From the perspective of market participants, the large-scale use and allocation of capital should be clearly authorized. The incident has reflected the ambiguous authorization of the large-scale capital transfer and allocation of Everbright Securities. Meanwhile, as the program trading has gradually become the mainstream trading model on the financial market, the fool-proof mechanism should be introduced in the design of the program trading software, so as to avoid stupid mistakes. The incident has shown that Everbright Securities’ risk control settings are useless and its huge loss on that day has shown that trading behaviors violating the market will surely be punished by the market. From the perspective of the regulators, it is necessary to carry out real-time monitoring on the abnormalities of capital above certain amount, so as to figure out the ins and outs of the capital.

A cross-market regulatory mechanism should be built.

During the incident, the market’s questioning on short positions by Everbright Securities on that afternoon has shown that there exist flaws on China’s securities market and futures market in terms of cross-market regulation. These flaws are the result of the missing of cross-market regulation, which is caused by the time-lag between the “T+1” trading on the securities market and the “T+0” trading on the futures market. The regulatory subject of the two markets is consistent, but the time-lag of the two markets will also lead to the high cost of cross-market regulation. Therefore, the cross-market regulatory mechanism can be designed especially for the above-mentioned abnormalities of large-scale capital. Once detecting the abnormality of large-scale capital, the cross-market regulatory mechanism should be immediately launched to avoid the recurrence of such extreme incident.

With regard to whether important events should be announced in the in-session trading, regulatory authorities should make careful consideration. If the fat finger incident was announced in the in-session trading, it would greatly impact the market; if not, Everbright Securities, in order to save itself, would reduce its short positions on the futures market to hedge against the risks on the securities market, which will make Everbright Securities to be involved in rule-breaking operations or even be suspected of conducting insider trading.

Program trading should not be over criticized.

The incident is caused by the trigger mechanism and the chain reaction of program trading, but the program trading cannot consequently be abandoned. The program trading is, in fact, a kind of trading in which traders input the trade logic in the form of algorithm into the computer so as to accurately seize any profit-making opportunity. At present, in the financial market of developed countries, the program trading has become the mainstream and therefore, the future development of China’s securities market cannot go against the general situation. At the technology level, the profit achieved by program trading is mainly through seizing any possible arbitrage opportunity. Such arbitrage trading can better promote price-finding of the financial market than the speculative trading and, at the same time, provide great liquidity to the market so as to enhance the market efficiency. On the other hand, both institutional investors and regulators should be more cautious when accepting and applying this trading mode and make careful evaluation in terms of trading logic, risk control and software design.

Importance should be attached to risk management function of the futures market.

In this incident, though Everbright Securities’ operation on the futures market has brought great controversy, the risk-avoiding function of the futures market is therefore more prominent. Futures, as the basic instrument to manage national economic risks, are very important, essential, and irreplaceable. The futures market can not only hedge against the risks in the spot market, but can also be included in the investment portfolio as a hedging tool to enable robust income of investment portfolio, which can be better realized in the treasury bond futures to be launched soon. As a result, the launch of the treasury bond futures should not be postponed as affected by the fat finger incident and, on the contrary, it should be launched as soon as possible given its key function in avoiding risks on the bond market.