Cancellation

What Is a Cancellation?

In the context of brokerage services, a cancellation is a notice sent by a broker to a client, informing them that an erroneous trade has been made and is being rectified.

When processing cancellations, industry best practices require that brokers maintain detailed records on all the actions taken to correct the mistaken trades.

Understanding Cancellations

Although brokerage services today are far more heavily automated than they have been in the past, erroneous trades still 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 mistakes 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 broker's handwriting. These kinds of errors have been substantially reduced due to the computerization of many of these processes, since orders that are directly 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 of a human error when one does occur. For example, a trader who commits a fat 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.

Example of a Cancellation

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.

Once the error is realized, the brokerage does several things In response. First, 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 — mainly by buying the XYZ shares the client wanted.

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.

Special Considerations

To help mitigate these risks, the Securities and Exchange Commission (SEC) approved rules in 2009 designed to control the incidence of erroneous trade executions. Under these regulations, 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.

The guidelines above are for regular trading hours. Since there is less liquidity in pre-market and after-hours trading, the percentage devitations to be considered erroneous are doubled, since there is less liquidity at those times.

To start the review process, the time of the transaction, security, number of shares, price of the transaction, side (buy, sell, or both), and a statement of why the trade is considered erroneous must be submitted to the exchange.