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NASDAQ OMX: THE FACEBOOK DEBACLE1

Ken Mark wrote this case under the supervision of Professors Deborah Compeau, Craig Dunbar, and Michael R. King solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Richard Ivey School of Business Foundation prohibits any form of reproduction, storage or transmittal without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Richard Ivey School of Business Foundation, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; email [email protected]. Copyright © 2013, Richard Ivey School of Business Foundation

Version: 2013-03-05

INTRODUCTION

May 18, 2012 should have been a great day for NASDAQ OMX. CEO Robert Greifeld had travelled to Silicon Valley to “join Facebook executives in remotely ringing the market’s opening bell”2 as part of the highly anticipated initial public offering (IPO) for the social media company. Having beat out New York Stock Exchange (NYSE) Euronext to be the listing exchange for the offering, all eyes were on NASDAQ as investors (and the media) waited to see what would happen to the Facebook stock. But as the time for the launch neared, problems in confirming last-minute orders were reported by various traders. g and . Two months later, on July 20, NASDAQ management reviewed the compensation plan that it was filing with the Securities and Exchange Commission (SEC). resulting from the technical glitches was much larger than the $40 million initially announced a few weeks ago but still less than what was being demanded by some institutional investors. Would the compensation plan satisfy the institutional investors who had participated in the IPO? Would the SEC view it as an adequate response? But, more fundamentally, how had this happened and what were the long-term implications of this incident?

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This case has been written on the basis of published sources only. Consequently, the interpretation and perspectives presented in this case are not necessarily those of NASDAQ or any of its employees. 2 J. Strasburg, A. Ackerman, and A. Lucchetti, “NASDAQ CEO Lost Touch Amid Facebook Chaos,” http://online.wsj.com/article/SB10001424052702303753904577454611252477238.html, 2012, accessed March 4, 2013.

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STOCK EXCHANGES: A MARKET FOR SECURITIES TRADING

The global market for securities trading was huge. In 2011, there were close to d with a combined stock market capitalization of $47.4 trillion. Trading in these stocks took place on Annual trading through the electronic order books managed by stock exchanges totaled $63 trillion, with 112 3 trillion trades with an average transaction size of $8,700. . Exhibit 1 shows the number of listed companies by exchange. Stock exchanges were a central part of the global financial system and served many purposes. Companies looking to sold shares to investors through ) with the shares listed on stock exchanges. Trading in these shares allowed investors to place a value on a company’s future prospects and, by extension, their firm. Investors — both institutional and retail — used stock exchanges and their electronic infrastructure when buying and selling shares to achieve their The transparency and liquidity provided by stock exchanges allowed investors to monitor their portfolios during the day and to funds among different investments with minimal trading costs. Dealers and traders at investment banks and stock brokers aimed to

Technological improvements over the past 40 years had transformed the way stocks were traded on exchanges. Over the past decade, the pace of trading had increased with market players relying increasingly on c . This complex and fast-paced system was overseen by a regulator, with the NASDAQ supervised by the SEC under the 1934 Securities Exchange Act. A glossary of terms in this case can be found in Exhibit 2.

NASDAQ OMX GROUP

Created as a in 1971, the NASDAQ was the . NASDAQ was created to allow investors to buy and sell stocks on a computerized, transparent and fast system that would eliminate the inefficiency of manual stock transactions. NASDAQ originally functioned as a computer bulletin board for trading 2,500 OTC securities. In 1982, NASDAQ National Market System was launched, offering real-time trade reporting for the 40 highest volume stocks. Then, in 1985, the NASDAQ-100 was founded as an index of the largest non-financial companies listed on the NASDAQ based on their market capitalization. During the 1980s and 1990s, the NASDAQ became the , attracting the initial listings for Apple (1980), Microsoft (1986) and Cisco Systems (1990). By 1994, NASDAQ surpassed the NYSE in yearly share volume. In 1998, NASDAQ secured its spot as the second largest U.S. stock exchange by acquiring the American Stock Exchange (AMEX). NASDAQ finally went public in July 2002 with its shares trading under the symbol “NDAQ.” In August 2006, the SEC finally recognized NASDAQ as a national securities exchange, completing its transformation into a global leader among national stock exchanges.

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http://www.world-exchanges.org/files/file/stats%20and%20charts/2011%20WFE%20Market%20Highlights.pdf, accessed September 15, 2012.

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. In 2006, NASDAQ made a for the London Stock Exchange in response to the NYSE's plan to acquire Paris-based Euronext NV. To cement its global footprint, NASDAQ then agreed to a friendly merger with Sweden and Finland’s OMX group, which controlled seven Nordic and Baltic stock exchanges. The closed in February 2008, and the combined entity was renamed the . Headquartered in New York with 30 global offices, the NASDAQ OMX had a market capitalization of $3.8 billion in mid-2012.

s. It generated $387 million in net income on revenues of $3.4 billion in 2011 with a return on equity of 6.8 per cent. NASDAQ managed trading for 3,400 global listed companies representing a total of $5.3 trillion in market value. Globally, NASDAQ operated 24 stock markets, three clearinghouses and five central securities depositories supporting all asset classes and the (Exhibit 3 shows the information processing requirements through the trading lifecycle). In terms of transactions, stock trading volume had risen exponentially from 20,000 per second in 2007 to 500,000 per second in 2009 and to several millions per second by May 2012.4 Exhibit 4 shows NASDAQ’s market share in trading. On May 2, 2012, NASDAQ unveiled what it called the

NASDAQ classified its business into Market services accounted for two-thirds of revenues in 2011. This segment generated fees from trading, clearing and settlement services across several assets classes, including cash equities, derivatives, debt, commodities, structured products and exchange-traded funds (ETFs). It also charged market participants a fee to access NASDAQ’s proprietary markets. Issuer services generated around 22 per cent of revenues in 2011 from fees charged to companies that listed on the NASDAQ OMX exchanges. This segment also managed NASDAQ’s stock market indices. Finally, the market technology segment accounted for the remaining 11 per cent of revenues. NASDAQ leased its proprietary technology for trading, clearing and settlement to 70 markets in 50 countries. Its clients were competing exchanges, alternative-trading systems, banks and securities brokers with marketplace offerings of their own. INFORMATION TECHNOLOGY IN STOCK EXCHANGES

The introduction of computerized trading “has gradually transformed the with little human or real-time oversight . . . Electronic technologies have profoundly altered how exchanges, brokers and dealers arrange most trades. In some cases, innovative trading systems are so different from traditional ones that most political leaders and regulators do not fully appreciate how they work and the many benefits that they offer to investors and to the economy as a whole.”5 Before electronic trading, stock trading was conducted by brokers and market makers who haggled over prices in person. Compared to the present day, stocks were traded infrequently and in large lot sizes. NASDAQ launched the first electronic market in 1971, leading the NYSE to invest heavily in its own electronic infrastructure. By 1978, the U.S. stock exchanges inaugurated the Intermarket Trading System (ITS), which provided an electronic link between the NYSE and competing exchanges, enabling brokers to 4 http://en.community.dell.com/dell-blogs/direct2dell/b/direct2dell/archive/2012/05/17/it-ensuring-a-strong-financial-heartbeatat-nasdaq.aspx, accessed September 15, 2012. 5 James J. Angel, Lawrence E. Harris and Chester S. Spatt, “Equity Trading in the 21st Century,” Quarterly Journal of Finance 1.1, 2011, p. 4.

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access all markets. Then, in 1984, the NYSE introduced the Super DOT 250 to route orders electronically between member firms and specialist trading posts staffed by designated market makers. With the increasing availability of computer power, the use of computers to execute trades became popular in the 1980s. So-called “program trading” (now termed algorithmic trading) could execute trades much more quickly than manual entries and thus improved both their speed and cost-effectiveness. Typical traders looked to buy or sell a security a handful of times a day at most and to hold securities for days, weeks or months. High-frequency trading systems, on the other hand, utilized algorithms to determine and execute trading strategies. These systems held investments for a

. By 2012, two-thirds of all share trading volume on U.S. markets could be traced to high-frequency trading systems.7

Trading software aggregated buy and sell requests for any of the stocks being traded on the market, then matched buyers with sellers as quickly as possible. An article in the Quarterly Journal of Finance lists some benefits of computerized trading systems: . . . computerized trading systems and high-speed communications networks allowed exchanges, brokers and dealers to better serve and attract clients. With these innovations, have dropped substantially over the years, and the market structure has also changed dramatically. . Secondary winners have been the exchanges, brokers and dealers who embraced electronic trading technologies and whose skills allowed them to profitably implement them. The big losers have been those intermediaries who did not innovate as successfully and, as a consequence, became less competitive and ultimately less relevant.8 Bob McDowall, an analyst at TowerGroup added: Without technology, exchanges could not accommodate the increased transaction flows that are generated both by the proliferation of end investors and by electronic trading, algorithms and low latency.9 IT Challenges for Exchanges

While technology supported exchange operations and securities trading in numerous ways, it also created risks. The situation faced by NASDAQ on May 18 was not the first time that trading software malfunctions had caused market issues. 6

Terrence Hendershott, Charles M. Jones and Albert J. Menkveld, “Does Algorithmic Trading Improve Liquidity?,” http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1100635, accessed September 15, 2012. 7 http://online.wsj.com/article/SB10000872396390443989204577599243693561670.html, accessed September 15, 2012. 8 Angel, Harris and Spatt, “Equity Trading in the 21st Century,” p. 3, accessed September 15, 2012. 9 http://www.computerweekly.com/news/2240083742/The-evolution-of-stock-market-technology, accessed September 15, 2012.

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On Monday, October 19, 1987, the Dow Jones Industrial Average fell by 508 points, or 22.6 per cent, in what was later known as “ .” The Commodity Futures Trading Commission, which worked with the SEC to regulate trading markets, identified the of the The SEC found that “the existence of futures on stock indexes and the use of various strategies involving g’ . . . were a 11 significant factor in accelerating and exacerbating the declines.” Mark Carlson of the board of governors of the Federal Reserve recounted what happened on Black Monday: There was substantial selling pressure on the NYSE at the open on Monday with a large imbalance in the number of sell orders relative to buy orders . . . In this situation, many specialists did not open for trading during the first hour . . . With stocks not trading, some of the quotes used to construct market indexes were stale, so the values of these indexes did not decline as much as they might have otherwise . . . By contrast, the futures market opened on time with heavy selling. With stale quotes in the cash market and declining prices in the futures market, a gap was created between the value of stock indexes in the cash market and in the futures market. Index arbitrage traders reportedly sought to take advantage of this gap by entering sell-at-market orders on the NYSE. When stocks finally opened, prices gapped down and the index arbitragers discovered they had sold stocks considerably below what they had been expecting and tried to cover themselves by buying in the futures market. . . . As stocks opened notably lower, portfolio insurers’ models prompted them to resume sales . . . Significant selling continued throughout the remainder of the day with equity prices declining steeply during the last hour and a half of trading.12 Some 23 years later, a similar event occurred. On May 6, 2010, at about 2:45 p.m. in the afternoon, the Dow Jones Industrial Average, already down by 300 points for the day, plunged another 600 points, or over 5 per cent in five minutes. While the market recovered most of the 600 point drop by 3:07 p.m., observers were left wondering what had triggered what was later known as the Flash Crash. Some pointed at the risk measures built into high-frequency trading systems as the reason for the crash. When a fund company decided to hedge its stock market exposure by selling futures contracts, the steep rise in volume triggered many trading systems to exit the market, accelerating the decline. As the SEC reported:13 At 2:32 p.m. . . . a large fundamental trader . . . initiated a sell program to sell a total of 75,000 E-Mini14 contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position . . . This large fundamental trader chose to execute this sell program via an automated execution algorithm that was programmed to feed orders into the June 2010 EMini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time. . . . the sell pressure was initially absorbed by high frequency traders [HFTs] and other intermediaries in the futures market; fundamental buyers in the futures market; and cross-market arbitrageurs who transferred this sell pressure to the equities market by opportunistically buying E-Mini contracts and simultaneously selling products like SPY,15 or selling individual equities in the S&P 500.

10 Roberta S. Karmel, “The Rashomon Effect in the After-The-Crash Studies,” The Review of Securities & Commodities Regulation, 21.12, June 22, 1988, p. 103. 11 Report by the Division of Market Regulation of the U.S. Securities and Exchange Commission, The October 1987 Market Break, February 1988, pp. 3–11, as cited in Karmel, “The Rashomon Effect,” p. 104. 12 http://www.federalreserve.gov/pubs/feds/2007/200713/200713pap.pdf, accessed September 15, 2012. 13 http://www.sec.gov/news/studies/2010/marketevents-report.pdf, accessed September 15, 2012. 14 The E-mini S&P, known as the E-mini, was a stock market index futures contract. 15 SPY was an exchange-traded fund that tracked the S&P 500.

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. . . between 2:41 p.m. and 2:44 p.m., HFTs aggressively sold about 2,000 E-Mini contracts in order to reduce their temporary long positions . . . [and] traded nearly 140,000 E-Mini contracts or over 33% of the total trading volume . . . The Sell Algorithm used by the large trade responded to the increased volume by increasing the rate at which it was feeding the orders into the market, even though orders that it already sent to the market were arguably not yet fully absorbed by fundamental buyers or cross-market arbitrageurs.

. Next, as the market was experiencing a lack of liquidity, HFTs began rapidly trading contracts to each other. Without any fundamental or cross-market arbitrage buyers, the E-Mini prices continued to fall, pulling down the S&P 500 with it.16 Just two months before the Facebook IPO, a systems malfunction caused BATS Global Markets to withdraw its own IPO — trading on its own exchange — after a software glitch sent its own shares plunging from $16 to less than one cent within nine seconds and Apple Inc.’s shares — also trading on the BATS exchange — down by almost 10 per cent.17 BATS, a registered exchange provider with operations in both the United States and Europe,18 had been founded in 2005 as an alternative trading system (ATS). Having converted to a national securities exchange in 2008, by 2012 it was the third largest exchange in the United States. Interestingly, BATS, like other national stock exchanges, was considered a quasigovernmental entity and thus had “absolute immunity on errors.”19 THE FACEBOOK IPO

With 900 million users around the world, Facebook was the dominant social networking site and was in May 2012. Launched in 2004, Facebook’s mission was “to make the world more open and connected.”20 Its key strategic goal was to attract and retain as many active users as possible so as to remain the top social media destination site on the planet. In 2011, Facebook generated $1 billion in net income from revenues of $3.7 billion. Touted as a “highly anticipated IPO”21 by many in the media, the final offer price valued the firm at $104 billion. It would trade on the NASDAQ under the symbol “FB.” The lead-up to the launch had caused some controversy. Initially expected to be priced in the high $20s to the mid-$30s per share, overwhelming interest from investors prompted the underwriters to boost the IPO pricing range to between $28 and $35 per share. On May 11, 2012, CNBC reported that Facebook’s IPO 22

the

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Buoyed by this enthusiasm, on May 14, 2012, the 3 Two days later, on May 16, 2012, Facebook announced that it would

http://www.sec.gov/news/studies/2010/marketevents-report.pdf, accessed September 15, 2012. 17 T. Lauricella, S. Pattterson and D. Benoit, “Trading Firm IPO Fizzles in Seconds,” Wall Street Journal, March 25, 2012, http://online.wsj.com/article/SB10001424052702304636404577299560502440118.html, accessed September 15, 2012. 18 http://batsglobalmarkets.com, accessed February 15, 2013. 19 http://financialservices.house.gov/uploadedfiles/hhrg-112-ba16-wstate-dmathisson-20120620.pdf, accessed September 15, 2012. 20 Facebook S-1, May 16, 2012, p. 1. 21 http://www.ibtimes.com/facebooks-highly-anticipated-ipo-planned-may-18-wsj-694373, accessed September 15, 2012. 22 “Facebook IPO Said ‘Many, Many’ Times Oversubscribed — CNBC,” Dow Jones News Service, May 9, 2012, http://www.djnewsplus.com/rssarticle/SB133675456713028774.html, accessed September 15, 2012. 23 “WSJ: Facebook Raises Price Range to $34 to $38 — Source,” Dow Jones News Service, May 14, 2012, accessed September 15, 2012.

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24 increase the size of its offering with the additional shares coming from existing shareholders. This offering was being viewed by some as expensive, 25 especially i...