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On May 18, 2012 one of the biggest initial public offerings in history was nearly destroyed by computers.
You know the company well. Facebook (NASDAQ:FB) is the most ubiquitous social media site in existence, with 900 million unique monthly visitors. But when it went public, investors became less concerned with the company’s number of users and more concerned with how many shares were trading.
When the dust settled at the end of the day, Facebook’s stock had set a new record for trading volume for an IPO. Over 450 million shares exchanged hands, in part due to the role of high frequency traders (HFT). But volume should have been much higher, and pricing should have been much more accurate.
What happened throughout the course of the day served as a warning to Main Street investors that stock exchanges can’t always be trusted, especially when there is an extreme spike in trading volume. And it helped highlight one of the problems with high frequency trading – too many orders in too short a period of time.
And at the heart of the problem was a glitch in Nasdaq’s computer software that couldn’t handle the “IPO Cross”.
An IPO Cross is the opening process for a new stock that’s about to go public. The process collects as many buy and sell orders as possible at a market-clearing price. When the stock is set to start trading, the computers do a quick double check to make sure no new orders have been submitted. This takes milliseconds. If new orders came in, the computer matches them up. If no new orders are in, then all is good to go.
In a proper IPO Cross, the high volume of orders are handled right off the bat. But Facebook didn’t have a proper IPO Cross. New orders kept coming in. Nasdaq’s computer software couldn’t handle the speed and volume. They got stuck in an infinite loop … searching and searching to match up all the new buy, sell and cancel orders.
This all happened around 11:00 am, when the stock was supposed to start trading. But with the computers overloaded, trading was delayed.
At 11:30, shares of Facebook finally started trading. But Nasdaq hadn’t actually fixed the issue. The exchange used a secondary matching system that used orders present at 11:11 am, a full 19 minutes before the stock hit the market.
Once the stock began trading at 11:30 am, it shot up to as high as $45, 18% higher than its $38 offering price. It seemed that things were on their way.
But they weren’t, at least not properly. Once the IPO Cross reports were released to the market at around 2 pm, it became clear that the first hour of trading was a mess.
The market learned that a backup computer had been used. And that orders entered between 11:11 and 11:30 had not been a part of the IPO Cross. In actuality, the price of shares didn’t accurately reflect demand for the stock.
The massive volume of entered and cancelled trades resulted in millions of dollars of trading losses for investors. To be sure, some made out like bandits. But others didn’t.
While it’s not unusual for a high-profile IPO to have many winners and losers, what makes Facebook’s different is that investors couldn’t trust the pricing and order quantities being handled by the computers. They only learned of the glitch afterwards, when trades had already been completed.
It’s still unclear how large an impact high frequency trading had on the Facebook IPO. What we do know is that computer algorithms and human traders were submitting buy orders and cancellation orders so rapidly that the computers were overwhelmed.
Only a deeper understanding of high frequency trading will help investors know how HFT firms contributed to what was almost the biggest IPO bust in history.
Best-selling author, Michael Lewis has one view – that HFT is a rigged game, designed to allow HFT firms to bank massive returns at the expense of Main Street investors. I don’t agree with everything that Lewis writes, but his easy going writing style and depth of research makes for a must-read book for anybody interested in the subject.
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