CASE STUDY – The India Flash Crash

Date 22nd October 2012 Authors Hirander Misra, Chairman & Tony Harrop, MD – Forum Trading Solutions Limited

Sequence of Events

On 5th October the National Stock Exchange of India (NSE) came to a

halt after an event now referred to as the “India Flash Crash”.

Early that day, one of the NSE members Emkay Global Financial Services (Emkay), entered a basket trade to sell 50 Scrip’s of Nifty and

9 other Scrips, and using their trading screen, entered the overall

parameters of the basket trade, worth 650 Crore. This was automatically split into separate orders with quantities based on their

pro-rata percentage constituent of the Nifty index.

However, a human ‘fat-finger-like’ error incorrectly transcribed the

value and quantity, resulting in extremely high amounts on each order.

Immediately following that, once the large sell orders began to be executed, the value of Scrips started to plummet.

The reduction in constituent company share value caused the Nifty

Index (recalculated 3 times each second) to drop dramatically as well.

This triggered an alert and the NSE finally halted trading.

After 15 minutes, the NSE reopened the market and further erroneous ‘in-flight’ orders were executed causing further dramatic falls in Nifty

securities which fell 16% and created panic among traders, with some

unjustly highlighting concerns that high-speed traders had brought instability to the markets even though this was a manual trading error.

The fact that Indian Exchanges do not have stock-specific circuit

breakers exacerbated the issue, because circuit breakers were only

applied based on the movement of their main index.

This incident briefly shaved almost $70 billion off the value of some of the country's largest listed companies.

The NSE’s response (Quote: ft.com, 5th October 2012)

The NSE explained that operational issues were the reason why the

market continued to fall to 16 per cent after the automatic cut-off had

been breached: “The second it hits 10 per cent the market stops accepting new orders, but there are always orders in flight … but in a millisecond you will have thousands of orders that have already gotten through the gate prior to the market stoppage and they will need to complete their execution.”

The unanswered questions?

Securities and Exchange Board of India (SEBI) Rules state that if either the NSE Nifty or BSE Sensex index falls by 10% before 1pm then trading should

halt for 1 hour on both Exchanges – why did the NSE only halt the market for 15 minutes?

The BSE did not halt their market. The NSE usually coordinates with the BSE when this kind of incident occurs, and decided:

“In this case, the market hadn’t really moved, and we decided to reopen ….. It was a mistake by only one member.”

(Quote: The FT, 5th October 2012)

This begs the question, what is ‘the market’ as the main index is a proxy for the market and in this case it did fall substantially? And why was the further

breach of the 15% threshold ignored?

Why did the NSE restart the market knowing that several Scrips had fallen

badly due to Emkay’s error and not investigate if other erroneous orders were about to be executed?

Why did the Exchange not spot the issue sooner – as soon as the first large

sell order hit the book?

Why were the controls on the order gateway not on the Exchange matching

engine itself?

Most importantly, why did the Exchange dismiss this as a member operational

issue by squarely apportioning the blame on Emkay and deny it was a technical system issue on their side – when surely an Exchange as the end

point where orders converge, should be there to ensure this kind of market disruption does not occur by ensuring the correct level of monitoring,

validation and control given that member errors can occur occasionally?

Market participants rely on this as the ultimate safety net to ensure market

integrity. This ‘explained as a member issue’ attitude means that this could happen again.

Warnings have been in the press that the potential for such an event exists:

“There’s nothing sinister in the new regulations. They should be broadly welcomed and bring India largely in line with best global practices,” says Hirander Misra, former COO of Chi-X Europe and now acting as a consultant for Indian exchanges.

“The quantity limit checks address ‘fat finger’ errors but I think a percentage of turnover safeguard would be more robust,” suggests Misra. “They also don’t have any circuit breakers in place, nor are they looking at that yet”.

(Quote: The Trade, 4th April 2012)

Inexplicably the NSE has not upgraded technology systems to provide better

event management, as they were reminded 3 weeks prior to this event

occurring: Hirander Misra: “It is wrong to say all problems were due to speed. Contrary to perception that speed increases risk, it also reduces it. Modern systems are designed for better risk management, Couple with cost effectiveness it equivocally reduces risk by providing market feedback at ultra low latency to enable real time risk management.”

(Quote: Business Standard, 13th September 2012)

With the current SEBI pressure on Indian RSEs to relaunch themselves, what should they be looking to do to restore confidence?

The answer is straightforward – build an Exchange trading system with the

right controls, which allows the monitoring and control to be proactive rather than reactive.

Control 1: Market Halt Mode

The platform should have the ability to switch to a ‘Halt’ mode as soon as triggered by an abnormal event. Then importantly within this mode it must

allow market supervisors to:

View the state of all orders including unmatched ‘in-flight’ orders

Provide sufficient time to allow members to pull erroneous orders in a

carefully monitored manner

If necessary cancel erroneous orders themselves

It needs to detect and act in a low-latency timescale – today that means the ability to react in a few microseconds.

The Exchange should always be one step ahead of the market

Control 2: Scrip Halt Mode

Similarly, it should have the ability to ‘Halt’ at individual security order-book

level and if multiple order-books are failing, then halt the whole market. The Nifty was made up of 50 Scrips and needed approximately 5 of these to

plummet 10 percent before the Nifty itself would trigger an alert.

Make sure this control is on the order-book matching engine itself not on the order gateway.

It’s no use locking the stable door after the horse has bolted.

Control 3: Full Band Controls

Band controls should be there to prevent issues occurring at source.

A price band will ensure that fat-finger entry of a price will be rejected

A volume band will ensure that fat-finger entry of a volume will be

rejected

A value band based on quantity multiplied by price will pre-empt the

impact of an erroneous order before it is even executed

Such bands should be flexible in the way they are applied across

segments, stocks and a per stock basis in line with market needs

To ensure that the controls don’t impact on a volatile but orderly

market, implement a mechanism to set the bands dynamically based on real statistical trade patterns

Stock specific price volatility interruptions of this nature can work in tandem

with percentage price checking of an order based on the last traded price as the latter may be breached if the order executes through multiple price levels

as appeared to be the case with the Emkay issue.

The presence of this control would have prevented the India Flash Crash.

Prevention is better than a cure.

Control 4: Market Supervision

An orderly market is supervised using sophisticated surveillance tools – these pick up on unusual order & trade patterns and alert Market Supervisors.

Standard alerts include unusual Volume and Price movement

Lessons Learned

These controls should be best practice for electronic markets globally. Had the NSE followed these best practice principles much of the pain both internally

and to the wider market would have been avoided.

Often issues are a result of dated legacy trading systems operating in

maturing electronic markets where volumes and the complexity of activity is

increasing, resulting in such systems rapidly being unsuitable.

Forum Trading Solutions follow this “best practice” ethos with our ForumMatch, Exchange trading platform, which we provide and operate for

Stock Exchanges globally.

But dialogue also needs to be held with SEBI to ensure that there is a clear definition of ‘the Market’ that each Exchange understands and that is not left

open to different interpretations.

Conclusion So in conclusion:

Human error will always occur and systems need to be put in place to

protect against this

Controls need to be proactive and spot the issues as they happen, not

reactive when it is too late

Adequate functions need to be available to suspend, review, detect

and repair

A culture of ‘prevention is better than the cure’ needs to be part of the

management ethos and feed down to operational teams

Technology is the enabler of good business practice, not something to

blame when things go wrong

In the event that a risk does become reality, a clearly defined

erroneous trades policy should also be in place

The Market and its Rules need to be extremely clear and not prone to

misinterpretation

Ultimately the Market will continue to evolve, and Exchange technology and its operation needs to adapt too in the best interests of the Market.

For further information contact: Forum Trading Solutions Ltd

Head Office: 16 St. Martins Le Grand

London, EC1A 4EN

+44 20 7397 8417

info@forum-ts.com

www.forum-ts.com

India Office: 506-A Sheetal Society

Juhu, Vile Parle West

Mumbai 400 049 +91 22 2620 2024