Bad Trades’ Ripple Effect; Most of Goldman’s Erroneous Orders to Be Canceled; Counterparties Face a Hit

Updated August 21, 2013, 7:56 p.m. ET

Bad Trades’ Ripple Effect

Most of Goldman’s Erroneous Orders to Be Canceled; Counterparties Face a Hit

JACOB BUNGE, KAITLYN KIERNAN  and JUSTIN BAER

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Goldman Sachs Group Inc. GS -1.54% won a preliminary victory to limit losses from a wave of erroneous trades that roiled U.S. options markets on Tuesday. After hours spent reviewing thousands of transactions, U.S. options-exchange officials on Wednesday decided to cancel most of the trades caused by a technical glitch in a Goldman trading system, people close to the matter said.

That could reduce potential losses for Goldman but hit a broad swath of trading firms that were on the other side of those transactions. People familiar with the matter on Tuesday estimated that Goldman’s losses from the mishap could run into hundreds of millions of dollars. The more trades the exchanges cancel, the lower Goldman’s costs.

Officials at exchanges such as NYSE EuronextNYX -0.66% Nasdaq OMX GroupInc., NDAQ +1.02% CBOE Holdings Inc. CBOE -0.27% and the International Securities Exchange spent Wednesday sifting through each errant transaction and informing traders which ones would be “broken,” or canceled. Each exchange has its own procedures.

Goldman and its counterparties have the opportunity to appeal those decisions, and exchange officials are considering some appeals, people familiar with the matter said.

The New York firm traced its misstep to an internal software system that helps determine the prices at which it would be willing to buy options from clients or sell options to them.

Goldman’s review of what led to the breakdown is continuing, and the firm hasn’t taken disciplinary actions against any employees as a result of the misstep, according to a person familiar with the matter.

Goldman isn’t the only trading firm dealing with the fallout from its wayward trades. Integral Derivative LLC, Barclays PLC unit Barclays Capital Inc., Citadel Securities LLC and Susquehanna Securities, a unit of Susquehanna Financial Group LLP, are among the specialists at NYSE Amex AXZ.AU -4.04% on a number of stock options affected by Tuesday’s glitch, according to a list posted to the NYSE website. Specialist firms are exchange members that facilitate the trading of stocks and options to ensure fair and orderly markets. They generally offset trades they enter into through additional stock or options trades.

The exchanges’ decision could set the stage for disputes by other options traders who say they were unfairly saddled with losses on related transactions.

“Other participants made a profit trading against Goldman,” said Thomas Peterffy, chief executive of Interactive Brokers Group, one of the largest traders of stock options in the U.S. and a pioneer of electronic options trading. Interactive was a counterparty in some of the erroneous Goldman orders.

 

Representatives at Integral Derivatives and Barclays Capital declined to comment. Representatives from Susquehanna Financial Group didn’t respond to requests for comment.

The exchanges haven’t disclosed the total value of the trades in question. At the NYSE, more than 816,000 options contracts in 31 listings traded at $1 a piece Tuesday morning, according to a Wall Street Journal analysis of data supplied by Trade Alert LLC.

Adding to the confusion, traders said, are U.S. options exchanges’ differing policies when it comes to defining erroneous trades and determining when such trades can be canceled. While exchanges have authority to decide the fate of trades that are made as the result of an error, they must follow their own rules that spell out which trades are canceled, which stand and which can be adjusted to a more reasonable price. Traders can then appeal those decisions with exchange officials.

“This [uncertainty] is the biggest risk to our business, and we’re seeing it play out in a grand fashion,” said Joe Van Hecke, managing director of Grace Hall Trading, a Chicago-based firm that was a counterparty in some of the Goldman orders Tuesday.

Some traders said they still were unsure of their positions Wednesday afternoon. Others said that, while Goldman bears responsibility for its error, the episode showed the need for exchanges to have stronger controls over wayward trades.

Goldman mistakenly issued orders to trade options linked to individual stocks and exchange-traded funds. In some cases, the orders were issued at prices far off the prevailing market. A Goldman spokesman Tuesday said the potential losses and risks associated with the error weren’t material to the bank.

The vast majority of the erroneous trades made by Goldman on NYSE’s Amex exchange were ultimately canceled, though some of these trades remain under appeal and will be ruled on over the next few days, a person close to the process said. Officials at the exchange—which people familiar with the trading said received most of Goldman’s errant orders—told traders Tuesday they expected to void most of the trades.

Nasdaq OMX and CBOE notified traders that their staffs had completed reviews of the previous day’s options trading and were telling customers which trades would stand.

Securities and Exchange Commission officials on Wednesday were monitoring the decisions on Tuesday’s trades to ensure they are consistent with exchange rules, people close to the process said. A spokesman for the SEC declined to comment on potential changes to options-market rules that could result from the episode.

Goldman’s snafu could ripple throughout the market. Specialists generally offset trades they enter into through additional stock or options trades. Those hedges might involve buying or selling shares or contracts as needed.

For example, if a specialist buys an in-the-money put option—or a contract that allows the buyer to sell shares at a price above the current stock value—he or she may then buy stock as a means of hedging that position. If those firms’ original trades with Goldman are voided, such firms could face losses on the related trades.

It is unclear what would happen to firms’ hedged positions if the initial trade was busted. One person familiar with the trading thought the stock and option hedges likely would stand. And with stocks generally trading lower Wednesday, specialists might be looking at a loss in some of those hedges.

Specialists might not have hedged against many obviously mispriced trades, the person familiar with the trading said.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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