Too fat, too fast: Dilemma posed by erroneous trades

In May 2010, when the Dow Jones industrial average mysteriously dipped 1,000 points in the blink of an eye, the “flash crash” was initially blamed on a “fat-finger” error, possibly from a trader mistaking “million” for “billion”. In a similar case in India, the Securities Appellate Tribunal (SAT) by an order dated 26 August 2014 while stressing the sanctity of trades on the exchanges upheld the decision of the National Stock Exchange (NSE) to refuse Emkay Global Financial Services’ plea for annulment of erroneous trades executed in October 2012.

Background

On 5 October 2012, a trader at Emkay punched in an order to sell 1.7 million Nifty 50 units worth a total of ₹9.8 billion (US$160.8 million) instead of an order to sell ₹1.7 million worth of Nifty 50 units. The sell order led to a transaction because the respondents placed unrealistic orders to buy Nifty 50 units at prices far from the market price, without adequate margin money.

The erroneous trades led to a plunge of over 900 points in the NSE’s benchmark Nifty 50 index, prompting a temporary halt in market trading.

Emkay, which lost about ₹510 million as a result of the trades, asked the NSE to annul the trades, saying they resulted from a one-off error. However, a panel constituted by the NSE to look into the matter rejected Emkay’s request.

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Analysis

SAT delved into the question as to whether the erroneous trade should be treated as a “material mistake”, which would require annulment under NSE by-law 5(a). SAT interpreted “material mistake” narrowly and reasoned that negligence or a breach of duty cannot be a ground to invoke by-law 5(a) and that the trades would not have occurred but for a failure in the risk management system of Emkay.

This stringent interpretation leaves no room for error on the part of trading entities and their dealers, which are cast with onerous obligations to establish and maintain a robust risk management system, reinforced by powers conferred on the stock exchange to penalize offenders to deter the lack of care and diligence.

Conversely, annulment of erroneous trades could provide a route for brokers to brush things under the rug to avoid being penalized for running a fragile risk management system. Further, identifying and establishing erroneous trades or orders is difficult even though all the orders are validated by the stock exchanges using pre-trade risk checks before accepting orders for matching. Practically speaking, stock exchanges may find it hard to identify whether an order was placed intentionally or was a result of an error. SAT, in this case, therefore, appears to have followed the principle of strict liability.

SAT also disagreed with the proposition that a “fat finger trade” should be annulled because the trader violated margin money requirements. It reasoned that annulling trades for this reason would virtually give traders a carte blanche to violate margin money norms and seek annulment when the trades are adverse to their interests. In such cases, annulment of trades would frustrate the objectives of margin money norms.

On the contractual aspect of trading transactions, SAT rejected Emkay’s argument that since the trades were based on a mistake by both parties as to the subject matter, they were void under the Indian Contract Act, 1872, and therefore liable to be annulled. Contrary to the stand taken by the Supreme Court in Senior Electricity Inspector v Laxmi Narayan Chopra (1961), SAT reasoned that the “Contract Act cannot be imported to present case, since laws governed securities market are adequate to deal with the present case and Contract Act, 1872 came into existence, when present day securities market did not exist or were even contemplated”.

Conclusion

It is interesting to note that SAT relied primarily on its interpretation of the NSE by-laws as the Securities and Exchange Board of India (SEBI) has not prescribed any regulatory framework pertaining to annulment of trades, though it did circulate a discussion paper cum proposal titled “Review of policy for trade cancellation/annulment” in October 2013. The paper recommended that an annulment of trade should be considered only in exceptional circumstances (such as market manipulation, fraud, and errors that affect price discovery), and that the circumstances for entertaining a request for annulment of trade be clearly defined. It is particularly interesting that SEBI proposed that the stock exchanges define the circumstances, parameters and safeguards pertaining to annulment of trades, instead of SEBI doing this itself.

The biggest dilemma posed by annulling erroneous trades remains the impact on other market players such as arbitrageurs, who may have taken or liquidated positions based on the prices after such trades and could suffer losses through no fault of their own if the trades are cancelled or modified.

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Suhail Nathani is a partner and Yogesh Chande is an associate partner at Economic Laws Practice. Malek-ul-Ashtar Shipchandler, a trainee, assisted with research. This article is intended for informational purposes and does not constitute a legal opinion or advice.