What really happened on May 18, 2012, with the botched IPO of Facebook Inc. (NasdaqGS: FB)?
Well, the Securities and Exchange Commission (SEC) just released its version of events under the guise of Administrative Proceeding File No. 3-15339.
And "In the Matter of THE NASDAQ STOCK MARKET, LLC and NASDAQ EXECUTION SERVICES, LLC (Respondents)" the SEC slapped wrists and fined the fools $10 million for screwing up Facebook's IPO - the largest-ever fine imposed on an exchange.
Of course, it's good reading. But there's something missing.
It's called "the truth."
How the Facebook IPO Was Supposed to Work
Here below in bold italics are excerpts from the actual order and my commentary (or the truth) in bold between the lines.
In its Introduction, the SEC states: National securities exchanges, which are registered by the Commission under Section 6 of the Exchange Act, are critical components of the National Market System, which provides the foundation for investor confidence in the integrity and stability of the United States' capital markets.
Which is all well and good if they practiced what they preach.
Except the SEC has aided and abetted the undermining of fair and orderly markets conducted at the exchanges. I'll get to that in a minute.
Here's how an initial public offering (IPO) is supposed to work.
Shares of the about-to-be-launched company are sold to participating purchasers (usually the fortunate ones) by the IPO's underwriters around midnight the night before the IPO.
"Secondary" trading, which is what happens when shares are released on the morning of the IPO, after they are priced, happens when the first "print" of the stock's price is announced and everyone can buy and sell based on the going price for stock.
Usually it's an easy process to get out the first "print" or the initial price of the offering.
Buyers and sellers place orders through their brokers and on their trading platforms for the amount of shares they want to buy or sell and at what price they want to transact.
The "display only period" (DOP) is the approximately 30 minutes it takes for orders to be put into the mixing bowl so that the largest number of shares aggregated at one price is "crossed" to determine the opening price.
In an IPO, if there are more buyers than sellers, the shares they buy come from the underwriters.
After the initial "print" is announced, secondary trading begins and underwriters sell their allotted shares to buyers wanting stock, and sellers who bought stock can sell in the open market. (Sometimes, a lot of the time, underwriters buy stock that's put up for sale, to keep the price up. But that's another story for another time.)
What mechanically happens in the mixing bowl during the DOP is handled by the IPO Cross Application at the NASDAQ exchange. The Cross Application matches the largest buy and sell orders at the same price (besides for IPOs, the Cross Application is what matches orders every day to open all stocks and to close all stocks). Because it's computerized, it takes the Application about one to two milliseconds to do its job.
Almost instantaneously, once the Cross Application has done its job, a "validation check" occurs. What's being validated is this: Are the orders in the Cross Application identical to the NASDAQ's matching engine? The matching engine matches up buyers and sellers, the number of shares and prices they are trading at, and is used to send confirmations to the trading parties.
If the validation check doesn't line up exactly with the Cross Application a "fail" occurs.
Quite often they don't line up. That's because orders get changed. For example, an order could get cancelled. The Cross Application then has to do its thing again. But it's no big deal; it does it in milliseconds. And then the validation check is run again, and so on. This "cycling" happens every five seconds until everything lines up.
The Real Story Behind the Facebook IPO
What happened with Facebook's IPO was that there were so many cancels and resubmitted orders that the normal cycle of a few milliseconds, cycling regularly to get to the cross, turned into a "loop."
You'd think NASDAQ would have planned for this eventuality better. They tried. They actually tested their live systems with a test security they labeled ZWZZT and had members send in orders. The problem was, they limited the number of test orders to 40,000. Why? Who knows, "It's a helicopter."
On May 18, 2012, the initial number of orders submitted into the Cross Application was 496,000 - roughly 12.4 times more.
In the SEC's words, The time that had elapsed during the price/volume calculation and validation check was 20 milliseconds, which is significantly longer than usual for an IPO cross, which usually takes 1 to 2 milliseconds. This additional length resulted from the larger than normal volume of orders received during the DOP.
Okay, here's the rub.
NASDAQ tested for 40,000 orders believing that the FB IPO would be hugely popular. But what they forgot about, because they forgot that they (the exchanges and the SEC) let buggers, I mean bugs - in the form of high-frequency traders with their faster computers - into the machinery that is supposed to facilitate smoothly debuted IPOs and...The orderly initiation of secondary market trading after an IPO (which "they" say is)one of the most fundamental functions of a national securities exchange, and affects not only the market for those individual companies but also investor confidence in the markets as a whole.
Of course there's nothing in the findings that remotely points to why there were hundreds of thousands of orders submitted and cancelled, over and over, and who might be behind most of those orders and cancellations.
It doesn't seem to matter to the SEC that on the CODE BLUE call of executives and programmers trying desperately to figure out what was happening and how to fix it, no one knew that Prior to receiving this report on May 18, the SVP/INET was unaware of the existence of the validation check.
That is, the Senior Vice President (on the Code Blue call) for INET, regulatory, and Data Services never even knew NASDAQ had a validation process!
Nor does it matter that two minutes before the IPO launch at 11:00 am, a large market-making broker-dealer requested the lead underwriter extend the DOP by five minutes.
Guess they figured out they needed more time to tee-up more clients or rig their quotes.
Nor does it matter that NASDAQ ended up with a short position in the stock as a result of the "fails," and when the price, fell it made over $10 million. (They had to give that up.)
NASDAQ announced on May 21, 2012 that it would contribute the $10.8 million in profits from its May 18, 2012, Facebook trading towards funding an accommodation policy. In a rule filing dated July 26, 2012, NASDAQ voluntarily proposed a $62 million accommodation program to compensate certain members for their losses in connection with the Facebook IPO. On March 22, 2013, the Commission approved NASDAQ's proposed accommodation policy as consistent with the requirements of the Exchange Act.
Nor does it matter that when the exchange restarted their machines after they executed a "failover" that bypassed the validation check - the one that the Sr. VP never knew existed - they didn't realize that they were 19 minutes behind and 38,000 orders upside down.
What does matter in all this - at least to me - is that the SEC won't admit that the problems just might have been caused by ghosts in the machines that they back-doored in because they are tools of the crony capitalists.
P.S. You can read the SEC's full report here... if you can stomach it: http://brokeandbroker.com/PDF/NASDAQFacebook.pdf.
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About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
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