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 Beijing-based 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."

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