What Is a Cancellation?
When processing cancellations, best practices require that brokers maintain detailed records on all the actions taken to correct the mistaken trades.
- Cancellation notices are sent by brokers to their clients when an error has occurred that affects one of the clients' trades.
- Brokers are responsible for promptly sending cancellation notices and to immediately begin correcting the mistake.
- Although errors have been reduced by the adoption of automated trading systems, they nonetheless remain a fairly regular occurrence.
Although brokerage services today are far more heavily automated than they have been in the past, erroneous trades nevertheless occur on a fairly regular basis. This can be due to any number of factors, ranging from complex technical errors involved in the automated trading systems to mundane administrative mistakes and human error. When errors do occur, brokers are required to promptly notify their clients of the mistake and begin documenting the steps taken to resolve the issue. If the brokerage firm is responsible for the error, they may be required to compensate the client for any adverse financial impact which it caused.
In the past, trading was conducted through a mixture of verbal and written communication, which created many opportunities for error, such as mishearing a verbal command or misreading a trader's handwriting. These kinds of errors have been substantially reduced due to the computerization of many of these processes, since orders that are explicitly entered into a computer system are almost always processed correctly by those systems.
On the other hand, one of the unintended consequences of computerization is that it can potentially amplify the negative impact when human error does occur. For example, a trader who commits a fit finger error—entering the wrong price or quantity for a trade, such as adding an additional zero to an order—could have little to no opportunity to correct their mistake before it is executed by the near-instantaneous computerized trading system. In other words, while past generations of traders may have committed more administrative mistakes, those mistakes may have been less impactful than they are today.
To help mitigate these risks, the Securities and Exchange Commission (SEC) approved new rules in 2009 designed to control the incidence of erroneous trade executions. Under these new rules, exchanges are permitted to cancel trades when the price offered differs by more than a specified percentage from the most recent prevailing market price of the security in question. In order to accommodate the fact that securities with different market capitalizations tend to vary with respect to their bid-ask spreads, the SEC outlined different percentage thresholds depending on the share price of the securities in question.
During regular market hours, the percentages stipulated by the SEC are 10% for stocks under $25, 5% for stocks priced between $25 and $50, and 3% for stocks with a value of $50 and higher. The SEC regulations also require that erroneous trades must be reviewed within one hour of the trade being flagged. Specifically, they require that the trade review must begin within 30 minutes of the trade being issued, while the review itself must be concluded within 30 minutes.
Real World Example of a Cancellation
To illustrate, consider a scenario in which a brokerage firm purchases 500 shares of XYZ Corporation on behalf of their client. Due to an administrative error, however, the floor broker puts in an order for 500 shares of ABC Corporation instead.
In response to this error, the client receives a cancellation notification outlining the error and clarifying that it is in the process of being rectified. Once they have notified the client, the brokerage firm must begin correcting the error. If the price of XYZ Corporation's shares were to rise prior to the trade being modified, then the brokerage firm may be required to compensate their client for the additional cost of executing the trade.