Talking Point

A never bright approach

How two seconds of madness triggered stock market chaos

CHINA-EVERBRIGHT/SUSPENDED

Overbought and overwrought: brokerage firm is being investigated by the regulator, its president has resigned

Until very recently Yang Jianbo was considered by his colleagues to be a “genius”, reports the 21CN Business Herald. Yang oversaw proprietary trading at Everbright Securities, a firm he joined in 2004 after getting a PhD in finance in the UK.

The newspaper says the individual in question likely shared his colleagues’ view. It adds that the 36 year-old was highly confident about his own abilities too. Apparently he once claimed to be “one of only two experts in China” who could arbitrage “risk free” profits in the complex world of quantitative stock trading.

His employer was also enthusiastic about his talents. In its annual report last year Everbright Securities described Yang’s division as its “new growth engine” explaining that his trading business had grown its income by 33 times over the previous year.

But last Friday something went wrong with Yang’s algorithms. His computer-based trading programme seems to have gone rogue in a day that rocked the Chinese stock market.

This saw Everbright place erroneous buy orders for Rmb23 billion ($3.8 billion) worth of shares. This, in turn, sparked an immediate 6% rally in the market, and a subsequent crash. In the days that followed Everbright has admitted to major losses on the trades. Meanwhile Yang and his team have been suspended pending regulatory investigations.

The affair has led to broader questions, not least what the mishap says about the competence of local financial firms and what it also might mean for ongoing attempts to reform the stock market.

And not surprisingly, this being China, there are a few conspiracy theories too…

What happened?

China’s stock market is notoriously volatile. But what happened on August 16 was extraordinary even by Chinese standards.

It started out as just another trading session. The key Shanghai Stock Exchange Composite Index (SHCOMP) was virtually unchanged from its previous closing level. But 95 minutes into the session, massive buying orders began flooding the market. Up to 71 stocks, led by index heavyweights such as ICBC and PetroChina, surged close to the 10% daily limit.

Rumours spread quickly among social media networks. “The Shanghai bourse’s system has a glitch?” one weibo user suggested. “Central Huijin is raising its stakes in state lenders again?” another asked. CBN noted that other analysts responded with euphoria. “The central government may finally be unleashing the stabilisation fund,” Cui Jun, chairman of Chuang Ying Investment said. “It is time to buy banking shares with your eyes closed.”

Anticipating that some high-rolling insiders were at work, retail investors then flocked to join the rally. The SHCOMP spiked 5.6% within three minutes.

Investors only started to get a better idea of what had happened when Shanghai-listed Everbright Securities was suspended from trading in the afternoon. The Shanghai stock exchange then blamed the rollercoaster ride on rogue trades committed by Everbright.

The session ended with the index marginally lower than the previous day’s closing level. Still, owing to the Everbright gaffe, total transaction volume on the Shanghai bourse climbed more than 40% to Rmb123 billion.

What triggered it?

It took nearly six months of investigation by US regulators to come up with a report on Wall Street’s 2010 flash crash (its findings, which put most of the blame on automatic trading programmes and high-frequency traders, remain disputed).

But thanks to the less sophisticated trading style in China, the culprit of last week’s fiasco was more swiftly identified. In a stock exchange statement published on Monday, Everbright Securities admitted that the chaos was caused by automatic trading systems that arbitraged an exchange traded fund (ETF) product on August 16. Initially three batches of buy orders were intended. These amounted to just Rmb5.5 million in market value. However, a deluge of 26,082 buying orders with a combined value of Rmb23 billion was placed instead, all hitting the market within two seconds. (Notably this far exceeded the Everbright trading operation’s daily limit, capped by Yang’s supervisors at Rmb80 million.)

Everbright then began cancelling the unintentional bids, but only after being warned by the Shanghai bourse. However, by this point up to Rmb7.3 billion worth of trades had been filled. The brokerage then reacted to its new positions by selling ETF units. More controversially, Everbright also hedged its position by shorting index futures aggressively. By the end of the day, the brokerage had short-sold 7,130 new contracts of September index futures.

Everbright later ruled out any human error leading to the trading fluke. Rather it blamed automatic systems that malfunctioned when “executing high-frequency trading at market price”.

How did the investing public react?

Costly and erroneous trades by fat fingers (traders typing in the wrong numbers) do happen. But the trend towards high-frequency computer-based trading has made flash-crash panics more common in recent years.

The rise of social media networks also accelerates the spread of rumours and amplifies market movements. (For example, a hoax in April from a hacked Associated Press Twitter account which suggested that the White House had been bombed briefly wiped $136 billion from the S&P 500 index.)

But in China, accidents are rarely taken at face value. Every high-profile incident prompts sceptics to look for underlying scandal (for example, when a fire destroyed a storage centre belonging to Sinograin most of the public was convinced that corrupt local officials had started it deliberately to escape exposure by state auditors looking for fraud, see WiC197). In the stock market, where investor confidence is anything but robust, the scale of Everbright’s error has given the sceptics more fodder.

“The whole episode can be compared to someone going to the supermarket for vegetables, but buying a luxury villa mistakenly instead,” Century Weekly wrote.

“Were these the system’s flaw, or the flaws by people who manage the systems?” Hu Shuli, editor-in-chief of the publication, wrote on its influential discussion forum.

The fact that August 16 also happened to be a settlement day for futures contracts fuelled further conspiracy talk (that Everbright was trying to profit by shortselling on the final day of a contract period, when there wouldn’t be time for bulls to reverse the position). “7,130 short-sold future contracts,” Hu added wryly, without further elaborating. “It cannot be simply a system error,” a reader followed up. “Are interests being colluded? Be it from brokerage to brokerage, or from brokerage to individuals? We will never know the answer.”

Others questioned why Everbright was able to execute more than Rmb7 billion worth of orders from an account supposedly operated with a daily limit of Rmb80 million. But most of all, the investing public was bitter that Everbright began short-selling the key index before making its trading glitch public in the afternoon trading session, an action that many regarded as constituting insider trading. “If Everbright’s massive long position in the morning was down to a trading glitch, what it did in the afternoon is purely market manipulation,” a fund manager told CBN.

So will Everbright be punished?

Everbright – one of the major state-run financial conglomerates – has said that it expects there will be ramifications. In fact the China Securities Regulatory Commission (CSRC) has already begun an investigation into a situation it described as “the first of its kind since China’s capital market has been established”.

So far the CSRC has banned Everbright from proprietary trading for three months. It is also prohibited the firm from creating new index futures positions.

Is worse to come? State mouthpiece Xinhua hopes so. It suggested that only a stern punishment could “brighten the A-share market”.

It added: “No matter if it was down to deliberate manipulation or system errors, the fiasco has disastrously destroyed investors’ fragile trust in A-shares. A hefty penalty is a must!”

The brokerage may also face civil lawsuits that could linger for years. A group of investors, lawyers and shareholder rights activists has already formed an alliance aimed at reclaiming their losses from Everbright.

When trading in its stock resumed on Tuesday, Everbright’s Shanghai-listed shares immediately plunged by the 10% daily limit. That alone equates to a loss of Rmb4.1 billion in market value. Another trading mishap on Monday, when Everbright mispriced Rmb10 million worth of bonds, did not burnish an already tarnished reputation.

“It is a shame that Everbright was one of the two window firms (together with the Citic Group) that Deng Xiaoping created to showcase China’s economic reforms,” wrote one disgusted weibo user.

Worse still, Everbright Bank, a sister firm of Everbright Securities, reportedly applied to list in Hong Kong only two months ago. It’s the third attempt by the state-run lender to IPO overseas, so the bank’s management might be justifiably worried that its prospects have not been aided by dint of its association with the securities house.

What lessons could be learned?

The flash rally on August 16 actually spoke volumes about the Chinese market, not least its lack of depth.

Most notably, the fact that Rmb7 billion in stock purchases was powerful enough to fuel a 6% spike within a couple of minutes. That’s in a market supposedly worth Rmb22 trillion. “It underlines the structural problem of our stock market, where the key index is vulnerable for manipulation,” the China Securities Journal reckoned.

Another lesson to be learned, according to the same financial publication, is that too many stock investors are ready to jump in giddily at the first rumour of government intervention. The recent flash rally was a “chain reaction”, the Xinhua-run newspaper declared, based on a “conditional reflex” created by years of meddling from state-controlled entities such as Central Huijin.

Changing that psychology will take years but a more immediate outcome is possible. The chaos caused by Yang Jianbo’s flawed trading operation will almost certainly prompt the regulator to get other Chinese investment banks to demonstrate that their own risk-control mechanisms are fit for purpose. Top of the agenda in this respect: ensuring they have systemic circuit-breakers that can detect (and cancel) massive erroneous buy or sell orders before they have time to wreak havoc on the market.

Yang himself has said nothing in public but has been suspended from his duties.

On Thursday Everbright Securities announced its president Xu Haoming had resigned.

Keeping track: to do a good job, as an old Chinese saying goes, one must sharpen one’s tools first. Everbright Securities must have ignored the traditional wisdom before trying out its “new growth engine” in risky high frequency trading.

In WiC205 we reported how a glitch in Everbright’s software wrongly generated Rmb23 billion ($3.8 billion) worth of buying orders in 2 seconds, which sparked an immediate 6% surge in the market and a subsequent crash on August 16.

According to the Guangzhou Daily, the software in question cost Everbright just Rmb100,000. But you get what you pay for – the system came with no circuit breaker. When they realised that the software had gone haywire, traders stopped the tsunami of unintended bids by pulling out the power plug and internet cords, the Century Weekly has reported.

The lesson is an expensive one. Everbright started short-selling index futures (a bid to square off its unwanted positions) before it told the market about the error. The CSRC ruled that this constituted insider trading and Everbright had to cough up all the illicit gain – Rmb87 million – and take a fine of five times as much. The penalty totalled Rmb523 million – more than half of the brokerage’s 2012 profit. The fine is the heaviest the CSRC has ever dished out.

Everbright bankers must be saying goodbye to their year-end bonuses, as well as farewell to some of their colleagues too. Four senior executives were banned from the securities market for life and Everbright has been barred from propriety trading in the stock and futures markets. Last but not least, Everbright’s board secretary was also fined Rmb200,000 for providing inaccurate information when confronted by journalists on that fateful morning. (September 6, 2013)


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