How Facebook’s IPO was bungled by Nasdaq’s computers

At last, electronic exchange Nasdaq has agreed to cough up $10 million dollars to settle SEC charges related to the bungling of Facebook’s May 2012 IPO. It was an ugly start to Facebook’s career as a public company, and the aftermath hasn’t been much better: Facebook has destroyed more than $40 billion in shareholder value since its shares debuted.

As part of the ritualized flaying of Nasdaq, the SEC published a terrific tick-tock on the details of what went wrong in the offering, which resulted in what the SEC called “a series of ill-fated decisions” from Nasdaq.

Diehard Facebook geeks will remember the delay that came before the shares started trading. So here’s what happened. When an IPO begins trading on the Nasdaq exchange, there’s typically a 15-minute “Display Only Period” (DOP) before the stock actually starts changing hands. During that timeout, the firms that buy and sell stock on the Nasdaq basically say how many shares they’re willing to buy and at what price. Importantly, during that period—which can be extended up to 30 minutes—those firms can also decide to cancel those orders.

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The Nasdaq also runs another computer program that cross-checks the buy-and-sell orders it uses to come up with the first trades in the new stock, in order to make sure those same orders exist in its “matching engine.” (The matching engine is the beating heart of a modern securities exchange, matching actual buyers and sellers and determining prices.)

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But the thing is, if the IPO Cross program had to recalculate the price, it would only factor in that initial canceled order. Meanwhile, the milliseconds tick by. And if additional order cancelations are received, that means the final validation check would fail again, triggering the IPO Cross to try to recalculate the first trade yet again. And that takes more time, which allows for more cancelled orders. And on, and on, and on. Turns out, this is exactly what happened on the morning of the Facebook IPO!

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Nasdaq’s cancellation-driven computer doom loop was just the opening act of Facebook’s IPO debacle. Nasdaq engineers eventually decided that the way to get this first trade done was to switch over to a duplicate version of its matching engine that didn’t conduct the validation check for cancelled orders. But that posed another problem: what that meant, in effect, was that Nasdaq itself was stepping in and essentially taking a short position in the Facebook shares it was covering for disgruntled customers (people who had unsuccessfully tried to cancel their orders).

Nine seconds after 11:30 a.m. in New York, trading of Facebook shares began, with 75.7 million shares of Zuckerberg & Co. changing hands at a price of $42.

At that point, it seemed like slaps on the back all around.

What Nasdaq didn’t know then, and wouldn’t learn until later that day, was that when it made the switch over at 11:30 a.m., Nasdaq’s computers were some 19 minutes behind on the actual orders because of the huge volume of trades. That meant that the price and orders on the initial cross were calculated using the data from 11:11 a.m., which left out some 30,000 marketable orders (Nasdaq called them the “stuck” orders) to buy and sell Facebook.

It also meant that Nasdaq had just acquired a roughly $129 million short position in some 3 million Facebook shares. Some 13,000 of those “stuck” orders hit the market just before 1:50 pm New York time (the rest were cancelled). Since most of them were sell orders, Facebook shares dropped when the stuck orders hit the market. It dismayed people who were banking on Facebook shares rising, but short-sellers were pleased to see the stock move lower.

It just so happened that Nasdaq was shorting shares of Facebook at that time. (Remember, it ended up with a short position because of the software snafu.)

So Nasdaq actually made roughly $10.8 million on the decline in Facebook’s shares. It contributed those profits to member firms that were hurt in the IPO mess. Nasdaq has agreed to pay $62 million to those firms.

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