China vets brokerages' computer systems after $3.8 billion buy error

China Everbright Bank.
Qilai Shen | Bloomberg | Getty Images
China Everbright Bank.

China's more than 110 brokerages will come under government scrutiny after Everbright Securities mistakenly made 23.4 billion yuan ($3.82 billion) of buy orders, collectively the biggest erroneous trade in Chinese stock market history.

The China Securities Regulatory Commission (CSRC) decided to widen its investigation of stock trading systems to all brokerages following its probe into a small Shanghai-based company that made the high-frequency trading software used by Everbright, a CSRC spokesman said.

The CSRC is trying to determine whether design flaws in the trading platform made by Shanghai Mercrtsoft Technology Co were responsible for Everbright's trading glitch on August 16. The malfunction caused the brokerage to place a series of mistaken trades that totaled 23.4 billion yuan ($3.82 billion), spurring a massive swing in Shanghai stock prices. Everbright has since replaced its president.

Everbright's trading error exposed shortcomings in China's trading systems and their oversight, industry experts say. It has prompted local securities firms to review their existing practices and may result in greater regulatory supervision.

(Read more: Goldman trading glitch could cost more than $100 million)

"The 'Mercrtsoft High-Frequency Trading and Investment System' that Everbright used was a customized system currently used exclusively by Everbright," the CSRC spokesman said in a question-and-answer transcript posted to the regulator's website late on Wednesday.

But he said the CSRC is also conducting inspections of systems in use at other brokerages.

Shanghai-based Everbright said a problem with its order execution system sent 26,082 erroneous buy orders directly to the Shanghai Stock Exchange last Friday morning over a two-minute period.

That sparked a flash rally that created and then wiped out roughly $100 billion worth of share value on the CSI300 Index in the course of a single day, Reuters calculations show. The CSI300 tracks the largest listed firms in China.

The incident has also thrown the spotlight on declining spending on information technology systems by China's brokerages.

(Read more: Uh oh. No one istracking these trading errors)

In recent years, securities companies have developed increasingly sophisticated proprietary trading strategies, allowing them to speculate with their own money in a widening variety of ways, as regulators have introduced more sophisticated instruments such as stock index futures.

But IT investment by brokerages hasn't kept pace.

Between 2010 and 2012, brokerage IT spending dropped 13.4 percent to 5.6 billion yuan, according to statistics compiled by CCW Research, a Beijing-based IT consultancy.

"When it comes to new financial products and business lines, the finance industry people understand the risks, but they're not familiar with how to use technology to mitigate those risks. They don't understand IT," said Guo Chang, deputy general manager at CCW Research.

Guo said brokerages have reduced IT expenditures due to the industry's weak profitability in recent years, but the Everbright incident should ensure that such spending does not decline any further.

(Read more: China's Everbright braced for punishment over trading glitch)

Brokerages such as GF Securities, CITIC Securities and China Merchants Securities could not immediately comment.

Mercrtsoft makes trading software for many of China's hedge funds, trust companies and domestic securities brokerages.

Its software is used by 17 brokerages and four futures companies, according to the official Xinhua news agency. The high-frequency trading software designed especially for Everbright was commissioned in February, Xinhua said.

A notice on Mercrtsoft's website said the company is "actively cooperating" with regulators and that employees continue to come to work as usual. The firm has closed the rest of its website.

At Everbright, the brokerage is replacing its current president Xu Haoming by a temporary president Yuan Changqing.

It has also suspended Yang Jianbo, head of proprietary trading, and replaced him with Li Haisong, head of the brokerage's risk management department.

Everbright shares have lost 17.6 percent since Aug. 16.

On Wednesday, the brokerage was ordered to suspend lead-underwriting of any new debt financing instruments of non-financial enterprises in the country's interbank bond market, after an unrelated trading mistake—this one caused by human error—resulted in a trading loss of $32 million.

The National Association of Financial Market Institutional Investors (NAFMII), which is appointed by the central bank to help supervise the interbank bond market, made the instruction and did not say how long it would last.

NAFMII demanded Everbright conduct a self-examination of its business processes, electronic systems, internal compliance, risk management and staff management, and submit its findings to the association together with a restructuring plan by Aug. 30, according to an Everbright filing to the Shanghai Stock Exchange.

Such glitches are likely to become a more common fixture of the Chinese markets as they grow increasingly complex, some analysts say.

"I think you'll see more problems like this as the industry evolves," said Mike Werner, an analyst for Bernstein Research who covers China's banks.

"As the banks bring more and more computer systems on board, you have to wonder how well these systems are tested. There's now more chance for human and operational risk at the brokerages, rather than just policy risk."