17-minute trading glitch put Goldman’s reputation on the line

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Last August, a technology malfunction left a leading Wall Street brokerage and market-making firm inadvertently holding billions of dollars in US securities.

And Goldman Sachs Group Inc. sensed an opportunity.

Within hours, the investment bank moved to offer to take a large portion of the position mistakenly accumulated by Knight Capital for a $200-million (U.S.) payment. The trade ended up being a lucrative one for Goldman.

Now, just over a year later, Goldman is discovering what it is like to be on the other side of an embarrassing technology mishap that could lead to tens of millions of dollars in losses and risks damaging the investment bank's sterling reputation in risk management.

A trading systems glitch at the bank this week saw it flood the U.S. market with orders that led it to purchase at least 800,000 contracts linked to equities and exchange-traded funds, disrupting trading on the country's leading exchanges.

The damage was swift. In just a 17-minute span following Tuesday's opening bell, Goldman's systems gobbled up contracts in certain trading symbols from the letter "H" to "L" including JPMorgan Chase & Co., Kellogg Co. and BlackRock's iShares Russell 2000 ETF.

"We had option volume in some names that was hundreds of times what they would normally trade in an entire day," says William Sterling of Trade-Alert, a market data analysis firm.

The mishap is the latest in a string of technology issues that have plagued U.S. markets since the "Flash Crash" of 2010, and is likely to embolden regulators who are worried the frequency and speed of computer malfunctions is damaging investor confidence.

The troubles are not limited to the U.S. Days earlier, a China-based brokerage, Everbright Securities, suffered a malfunction that saw it purchase nearly $4-billion worth of shares on the Shanghai market, sending the market soaring until the trades were broken up.

At Goldman, employees scrambled to deal with the morning's trading chaos by assembling an emergency team of traders and specialists, some of whom had to be recalled from their vacations. The incident drew the attention of senior executives, including Gary Cohn, chief operating officer.

Goldman staff briefed the in-house regulators positioned at the bank. Officials from the U.S. Securities and Exchange Commission, including the watchdog's enforcement division, prepared for internal meetings to try to determine what went wrong at the bank and whether any violations took place.

Computer systems that measure the bank's interest in buying or selling a securities were in the process of being updated and started accidentally sending internal signals to outside exchanges as executable orders, a person familiar with the matter said.

U.S. exchanges began the process of attempting to untangle the trades between Goldman and its counter-parties as heated discussions took place over whether it would be proper to cancel, adjust or hold up the trades. The decisions will affect what Goldman's losses may ultimately be.

Unlike the Knight trading glitch, many of Goldman's trades have qualified for cancellation under exchange rules that have raised concerns among counterparties over the risks associated with breaking up the transactions.

Myron Scholes, a co-author of the Black-Scholes formula of options pricing, has criticized the decision to break some of Goldman's trades.

"This incident distinguished itself from Knight because Knight blew itself up and had little impact on others," said an executive at a Wall Street trading firm, who recalled Knight's unsuccessfully lobbying of U.S. exchanges and the SEC to cancel their inadvertent trades.

"In this case, the exchanges are busting trades and that is coming to the detriment of others besides Goldman – and the tune of that detriment can be quantified by the number of shares left unhedged after the busted trades."

Others have pointed out that the guidelines on options differ from those for stocks, adding that many of Goldman's mistaken trades met guidelines for cancellations where as Knight's did not.

Goldman has yet to provide a public estimate of its trading loss.

Still, even if Goldman's losses end up being minimized as its faulty trades are torn up, the week's events are likely to sit uncomfortably within the bank. It has prided itself on its risk-management procedures and back-office team, nicknamed "the federation." One insider described the glitch as "highly embarrassing."

Fallout from Goldman's trading misadventure could spread beyond the bank to the wider Wall Street.

Chris Nagy, who runs KOR Trading and a former board member of the NYSE AMEX options exchange, said "Goldman's misfortune is nothing close to the Knight-mare," which led to Knight being rescued in an industry bailout and later acquired by a rival trading firm. "But it's another black eye that taints the industry."