Botched Facebook IPO Brings|NASDAQ a $10 Million Fine

WASHINGTON (CN) – The NASDAQ will pay $10 million for screwing up Facebook’s IPO, the SEC said Wednesday.
     The NASDAQ’s electronic system of checks and cross-checks of orders failed in the early moments of the stock offering, and NASDAQ’s operators then made some poor decisions which violated market rules, the SEC said in a statement and in its settled, cease and desist order. The snafu caused more than 30,000 buy and sell orders for Facebook to be stuck in limbo for more than two hours.
     The NASDAQ and the SEC attributed the problem, or some of it, to the size of the May 2012 IPO and the widespread interest in it.
     The SEC order states: “In a typical IPO on NASDAQ, shares of the issuer are sold by the IPO’s underwriters to participating purchasers at approximately midnight and secondary market trading begins later that morning. Secondary trading begins after a designated period – called the ‘Display Only Period’ or DOP’ – during which members can specify the price and quantity of shares that they are willing to buy or sell (along with various other order characteristics), and can also cancel and/or replace previous orders. The DOP usually lasts 15 minutes, although NASDAQ’s rules permit the DOP to be extended by up to 30 minutes (in 5 minute intervals) if certain conditions related to the balance of buy and sell orders are met.
     “At the end of the DOP, NASDAQ’s ‘IPO Cross Application’ analyzes all of the buy and sell orders to determine the price at which the largest number of shares will trade and then NASDAQ’s matching engine matches buy and sell orders at that price. (The matching of the buy and sell orders is referred to as the ‘cross.’) The electronic calculation by the IPO Cross Application usually takes approximately one to two milliseconds to complete.
     “NASDAQ’s systems ran a ‘validation check,’ which would confirm that the orders in the IPO Cross Application were identical to those in NASDAQ’s matching engine. One reason that the orders might not match is because NASDAQ allowed orders to be canceled at any time up until the end of the DOP – including the very brief interval during which the IPO Cross Application was calculating the price and volume of the cross. If any of the orders used to calculate the price and volume of the cross had been canceled during the IPO Cross Application’s calculation process, the validation check would ‘fail’ and the system would cause the IPO Cross Application to recalculate the price and volume of the cross. The validation check had been in place for NASDAQ’s IPO cross process since December 2010, and a similar check had been in place in NASDAQ’s market opening and closing cross processes since 2006.
     “This second calculation by the IPO Cross Application, if necessary, incorporated only the first cancellation received during the first calculation, as well as any new orders that were received between the beginning of the first calculation and the receipt of that first cancellation. Thus, if there were multiple orders canceled during the first IPO Cross Application’s calculation, the validation check performed after the second calculation would fail again and the IPO Cross Application would need to be run a third time in order to include the second cancellation, as well as any orders received between the first and second cancellations.
     “Members are permitted to place certain types of buy and sell orders starting at 7 a.m. – before the Display Only Period begins – but such orders are placed in a ‘holding bin’ until the beginning of the Display Only Period.
     “Because the share and volume calculations and validation checks occur in a matter of milliseconds it was usually possible for the system to incorporate multiple cancellations (and intervening orders) and produce a calculation that satisfies the validation check after a few cycles of calculation and validation. However, the design of the system created the risk that if orders continued to be canceled during each re-calculation, a repeated cycle of validation checks and re-calculations – known as a ‘loop’ – would occur, preventing NASDAQ’s system from: (i) completing the cross; (ii) reporting the price and volume of the executions in the cross (a report known as the ‘bulk print’); and (iii) commencing normal secondary market trading. This risk was greatest during crosses in which a large volume of orders and cancellations were submitted in rapid succession during the brief period of the cross calculation process.”
     Unfortunately for NASDAQ, in testing its “cross” system before the May 18, 2012 IPO, it limited its tests to 40,000 dummy orders. But on the day of the IPO there were more than 496,000 of them.
     NASDAQ will pay a $10 million fine and try to fix it. As is customary with SEC orders, the stock exchange did not have to admit it did anything wrong.

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