A dishonest Mistake

Everbright Securities Co. Ltd.， China’s fifth largest brokerage by market value， is under investigation after design flaws in its trading system triggered an unexpected huge buy and caused a startling rise in domestic A-share stocks on August 16.

On the morning of that day， China’s stock markets had a roller coaster ride when the benchmark Shanghai Composite Index spiked 5.96 percent within three minutes before easing back in the afternoon. Almost all blue chips， including Industrial and Commercial Bank of China， Baosteel， Shanghai Pudong Development Bank， Agricultural Bank of China and Bank of Communications， hit their daily trading limits of 10 percent.

Traders and analysts called for an immediate investigation into possible price manipulation and insider trading. Experts say the securities sector is in dire need for more risk controls to protect individual investors， while short-sellers were furious and urged authorities to probe the case and come up with a compensation plan.

What happened？

Immediately after the dramatic flash rally in the morning of August 16， the Shanghai Stock Exchange checked its trading and technical system and found nothing wrong. Later， the bourse learned that all buy orders came from an Everbright Securities account and sent Shanghai securities authorities to inspect the cause. The China Securities Regulatory Commission （CSRC）， the country’s securities supervisory authority， then launched an investigation.

An initial probe showed that the accidental buy orders from an Everbright account was due to a technical glitch， the CSRC said in a news release on August 18. “It was not human error， but design flaws in a trade unit of China Everbright Securities that triggered the anomalous trades，” reads a CSRC statement. “China Everbright Securities has obvious defects in internal controls， and information system management exposed serious problems.”

The commission said the company sent a 23.4-billion-yuan （$3.71 billion） order to the Shanghai Stock Exchange and closed deals valued at 7.27 billion yuan （$1.15 billion） on the morning of August 16. Later that day， the brokerage sold 1.85 billion yuan （$293.65 million） shares in terms of exchange traded funds and launched short selling of 7，130 board lots or 71，300 stock index futures contracts， to hedge its losses. Short-sellers saw big losses because of the surprising surge in the morning， as August 16 was the date for index futures settlement.

The Shanghai Securities Regulatory Bureau stopped Everbright Securities’ related business and is investigating who is responsible for the error.

Everbright Securities initially denied its mistake caused the dramatic morning surge， but later admitted fault.

On August 18， the brokerage held a press conference， saying its strategic investment department’s proprietary trading bureau encountered a problem when using its own arbitrage system.

“After placing an 80-million-yuan （$12.7 million） buy order at 11：02 a.m. on August 16， the arbitrage system didn’t get feedback as it usually does. Then， the system made a wrong judgment and made repetitive orders，” said Xu Haoming， President of Everbright Securities， who later resigned over the incident.

Because of a T+1 system in China’s spot stock market， the brokerage could not sell shares it bought on the same day， which forced it to build huge short positions in the index futures market， totaling 7，130 lots， the brokerage said. The company also said it was met with 194 million yuan （$30.8 million） in losses because of the system error and apologized over the incident.

This event has pushed the brokerage across the regulatory red line， and the company may receive warnings or a punishment from the regulator. “It may also restrain business performance and damage our brand，”read a company statement.

Everbright board secretary Mei Jian pledged at the conference to fulfill compensation responsibilities to investors if the CSRC ordered so after the investigation.

Trading of the brokerage’s A-shares resumed on August 20， ending with a drop that hit trading limits. The company’s proprietary trading in stocks in the spot market has been suspended for three months until November 18. At least four fund companies lowered their valuation for Everbright Securities， with the highest decline being 15 percent.

Market loopholes

CSRC said in the statement the Everbright incident was the first extreme case of its kind since the establishment of a capital market in China， which raised red flags for the entire securities sector.

An editorial from Hong Kong Economic Times said the incident revealed at least three flaws： the lack of a warning system in the bourse， the lack of a mechanism to cancel buy orders and a difficulty in tracking accountability.

Yang Zhaoquan， a securities lawyer， said Everbright Securities made three mistakes. First， its hefty buy orders have led to major market fluctuations. It’s suspected of being involved in market manipulation. Second， soon after the incident， board secretary Mei denied market rumors. He is suspected of misleading investors. Finally， before the incident was revealed to the general public， Everbright Futures launched short selling of 7，130 board lots or 71，300 stock index futures contracts， to hedge its losses， arousing suspicion of insider trading， said Yang.

Stock analysts said the incident demonstrated the existence of loopholes in the trading process used by Chinese brokerages.

Shi Jianxun， a professor in economics from Shanghai-based Tongji University， said risk control on investment trading is not that difficult.

“The company can set an investment quota for traders. For instance， one trader can only handle less than a 100 million yuan（$15.87 million） investment， while any investment over 1 billion yuan （$158.73 million） should get approval from the director of the department and any investment over 10 billion yuan （$1.59 billion） should be operated jointly by at least three people，” said Shi.

“If those securities companies adopted corresponding measures on transaction authority and risk control， errors are unlikely to occur. The most urgent task for financial institutions is to inspect and upgrade their trading systems to avoid such incidents.”

Ke Jingmin， a partner with the Beijingbased Derun Law Firm， said the CSRC should investigate whether Everbright Securities has manipulated the stock market during the process.

“Everbright Securities made several mistakes. First， the company has serious flaws in internal risk control. Globally speaking， any investment over 100 million yuan（$15.87 million） should at least get approval from four levels of staff. Second， it breached the CSRC regulation on the quota of equity investment. The CSRC regulates that proprietary equity securities trading and derivatives from securities companies should be less than the net asset of the brokerages.”

“As for victim investors of the trading system glitch， they can wait for investigation results from the CSRC. After that， they can negotiate with Everbright Securities about compensation. If the two sides fail to reach a consensus， victims can file complaints to the CSRC or sue Everbright，” he said.

However， analysts say it is difficult to know how many investors were impacted by the error， and whether there is a clear legal ground for compensation.

Jiang Mingde， chief economist with the Sinolink Futures， said the incident rings an alarming bell for supervisory authorities.

“Right now， programed trading is commonly used and similar incidents have occurred in many countries. When there is an emerging usage of innovations such as programed trading， the internal control from companies and risk control from supervisory authorities should follow up with the pace of innovation，” said Jiang.

China’s stock markets already have some basic curbs to keep volatility in check. For instance， stocks are allowed to rise or fall by only 10 percent in a single trading day. But further constraints need to be added to protect investors from market turbulence， experts say.

The incident highlights the need to improve the market’s “fuse” mechanism. Such mechanisms， which automatically suspend stocks during periods of unusual adjustment， are now common throughout most Western markets， said Jiang.

Yin Zhongli， Deputy Director of the Institute of Finance and Banking at the Chinese Academy of Social Sciences， said the bourse is partly responsible too， for a lack of warning and business suspension systems. The bourse should establish a risk control and warning system to automatically warn traders of too high or too low priced trading or hefty amounts of trading. Also， once the bourse detects abnormal buy orders， it should immediately release an announcement to warn investors and suspend any suspicious accounts.

“In this Everbright Securities incident， the bourse released its announcement after consulting with the securities company. Therefore， the bourse announcement didn’t come out until the afternoon， several hours after the glitch took place， taking a toll on stock and futures investors，” said Yin.

“When Everbright Securities was selling out to hedge its losses after the incident， countless uninformed investors made wrong decisions and ordered large-scale buy-ins.”