This article considers some of the risks and regulations associated with error trades on commodity exchanges in an increasingly demanding regulatory environment.
In June 2015, a Deutsche Bank trader mistakenly sent a client US$6 billion. The ‘fat finger’ error occurred when a junior trader processed a trade using the gross rather than the net figure, resulting in a trade with ‘too many zeroes’. Deutsche Bank was swift to resolve the issue and reported the incident to various regulators in the US and Europe.
In September 2015, it was speculated that a ‘fat finger’ trade was responsible for a fall on the London Stock Exchange (LSE) so sharp that it suspended trading in several energy and mining stocks for several minutes.
Having systems in place to avoid mistakes occurring is the ideal. Deutsche Bank operates a “four eyes” policy, which requires every trade to be reviewed by a second person before being processed. It is not clear why the trader’s error was not identified through application of this policy.
Commodity exchanges and the Futures Industry Association (FIA) encourage members to establish controls to prevent ‘fat finger’ errors.
ICE Futures Europe (ICE) considers that both members and the exchange should have controls to prevent entry of erroneous orders. While acknowledging that trades substantially different from market price may damage users’ confidence in the market, ICE considers that market integrity demands that transactions should not be adjusted or cancelled arbitrarily. To this end, ICE sets a No Cancellation Range (NCR): any trades within the price range will not normally be altered, even if executed in error. ICE has, however, established procedures to prevent ‘fat finger’ trades, by also setting price reasonability limits outside which its platform will not execute orders.
The London Metal Exchange (LME) recently reminded members to take “proper care and attention...when submitting orders” and to have appropriate procedures to prevent error trades. The LME warns that those who fail to do so or create a disorderly market are liable to disciplinary action, as they are on other exchanges.
In 2012 FIA Europe published guidance on systems and controls for electronic trading environments to establish an industry standard for venues and firms, including examples of pre-trade risk limits such as maximum order values.
In the UK, the Financial Conduct Authority’s (FCA) Principles for Business require each regulated firm to “take reasonable care to organise and control its affairs responsibly and effectively with adequate risk systems” and to have “adequate, sound and appropriate risk management processes and internal control mechanisms”. In this context the FCA endorses the guidelines on systems and controls in an automated trading environment issued in 2012 under the Markets in Financial Instruments Directive (MiFID) by the European Securities and Markets Authority (ESMA). But the FIA’s guidance is relevant too, given the FCA does not prescribe detailed rules for every area in which systems and controls standards apply.
From 2017-18, these regulatory requirements will be further strengthened under MiFID II. Detailed requirements will apply not only to high frequency and “algorithmic trading”, defined as involving “limited or no human intervention”, but also to trading venues and to firms that provide direct electronic access to them. ESMA draft regulations under MiFID II, sent to the European Commission in September 2015, set out a range of pre-trade risk controls to be implemented by both investment firms and trading venues.
Europe is not alone in formalising requirements in this area in both commodity derivatives and/or securities. For example, in 2013 the US Securities and Exchange Commission (SEC) replaced its previous circuit breaker rule with a “limit up, limit down” regulation designed to prevent trades in individual stocks from occurring outside specified price bands and which could respond more sensitively to erroneous trades as well as dealing with major price moves.
The practical implications of both exchange restrictions on unwinding erroneous trades and the increasing level of regulation highlight the importance of regulated firms, other market participants and venues themselves seeking practical legal advice to establish procedures to guard against ‘fat finger’ errors, to ensure compliance with all the relevant regulatory requirements and to resolve claims and regulatory enforcement issues when errors do occur.