In despair, he contacted the Trading Surveillance Office of the Frankfurt Stock Exchange with his problem. He had placed a market order (order without a price limit) for 2.4 million warrants on the German stock index (DAX). Prior to him placing the order, his bank’s online brokerage tool had calculated that this order would cost him EUR 2,400 plus fees. This calculation was based on the last price established on the stock exchange selected by the investor.

The investor was unaware that this procedure was based on a price without turnover (PWT), the bid price of the issuer of the warrant on the Frankfurt Stock Exchange. The bid price is the price that the issuer will pay to buy back a warrant. However, to execute a buy order, the issuer’s offer price was the relevant price, i.e. the price at which the issuer was prepared to sell the warrant. In this particular case, this offer price was EUR 0.065, significantly higher than the bid price of EUR 0.001.

Presumably the investor would have noticed his mistake if the bank holding his account had calculated the potential value of his order on the basis of actual bid and ask quotes that were available during trading hours, and not on the basis of the last available price. Even if he had then tried to place the order after the order value had been indicated, his bank would not have accepted his order calculated in this way due to insufficient funds on his account. As this was not the case, the order was transmitted to the stock exchange and executed in accordance with the exchange regulations and the underlying market model. It was the investor’s loss.

Not an isolated case

Unfortunately, this is not an isolated case of a layperson paying dearly for his ignorance. On the contrary, similar issues arise frequently. The stock market experts with responsibility for price fixing often recognise such securities orders and contact the bank placing the order with information on the price. However, this is not really one of the roles of a stock exchange and is not a guarantee that this type of situation will always be spotted in time.

Cases where the bank cannot reach the end client right away also pose a problem, as the bank must then decide for itself whether the order should be cancelled or executed.

Market survey

The Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin) carried out a market survey together with the Trading Surveillance Office of the Frankfurt Stock Exchange to gain an overview of the way banks’ online brokerage tools work, and to assess whether information provided is fair, clear and not misleading for clients.

This survey focused on the calculation of the indicative order value, i.e. the amount shown to clients immediately before they place a binding securities order. The order value is therefore often also called the “provisional amount to be paid” or the “provisional order value”. It is calculated as the number of securities in the order multiplied by the price of the security.

BaFin also checked the security mechanisms of banks for investor protection and their procedures for dealing with queries from trading surveillance offices and stock exchanges.

Findings and implications

The market survey revealed that, for the most part, online brokerage tools do not use the current bid and ask prices to calculate the indicative order value. However, these price quotes reflect the current market situation and therefore represent the best basis for calculation, as only this information provides investors with a realistic order value that is fair, clear and not misleading. The current market situation is particularly crucial for securities with a price of below one euro. This applies to penny stocks, but may also be the case for certificates and warrants. For these securities, there may be significant price fluctuations within a trading day, purely on the basis of the spreads. There may also be other reasons why price information from the morning may in some circumstances already be out of date by late afternoon, for example in the case of foreign shares traded on a regulated unofficial market, for which the reference market only opens in the afternoon.

As mentioned, if the last stock exchange or market price is used to calculate the indicative order value for illiquid securities, this may also be a price that was fixed without any actual turnover in the relevant security. If due to the bid and ask situation no trades are executed during the trading period, then a PWT is fixed for information purposes for the trading participants. This is always based on the buy side of the quote (bid price). The price without turnover (PWT) is therefore not a trading price . Instead, it provides the price at which investors can sell securities. For securities with low demand, the price is often below 1 cent. The relevant ask price for an investor wishing to buy often differs substantially from this price. This ultimately leads to investors placing orders they would not have placed had they been aware of the actual ask price.

It is better if the bank makes additional arbitrage lists available to investors. These show prices on other stock exchanges and markets where the security is traded. In each case, there is also an indication of whether these are real-time/near real-time or other prices, e.g. closing prices. In this way, at least investors would be aware that the actual execution price may differ from the indicative order value. However, the method is less certain than a calculation based on the current bid or ask price, as there is no guarantee with arbitrage lists that the investor actually takes note of the information.

Security mechanisms for investor protection

In some circumstances, it is not a problem that the price used to calculate the indicative order value does not correspond to the relevant side of the trade: namely, if the bank already has appropriate security mechanisms in place to protect investors from the detrimental order execution situation described.

The market survey found that practically all of the banks concerned have a security mechanism that checks the available funds on the client’s account prior to order execution. However, the problem here is that the price used when performing this check is the indicative order value, which may be based on price information that is out of date. If this is the case, then the check against available funds is also made on the basis of an out-of-date price. Such an account check cannot therefore effectively protect the investor from the order being executed at a significantly higher than expected price.

Some banks already require their clients to limit orders for securities with a current price of below one euro. The reason for this is that up until now, in cases with a significant difference between the indicative and the actual order value, the price of the security has always remained well below the one-euro mark. This approach represents the only effective security mechanism. It avoids the risk that the order is executed at a significantly higher price than expected by the investor, since the execution price cannot exceed the investor’s chosen price limit. If such a limit is not obligatory, investors should be advised to place limits of their own accord when buying such securities.

Other security mechanisms were less effective at protecting investors. Some banks simply suggested to investors that they should place a limit; others indicated their willingness to cancel orders retrospectively. However, warnings may simply be ignored by investors when basing their buying decisions on price information that is out-of-date; and to cancel an order retrospectively, investors depend on the goodwill of the bank.

How banks handle queries

As already indicated, in many cases, the units responsible for price fixing on the trading venues manage to identify high volume market orders from retail investors and ask the bank placing the order to check its accuracy prior to execution. However, the method of dealing with such queries from stock exchanges and trading surveillance offices varies from bank to bank. The best case scenario is when an institution has a standardised procedure with clear rules for such situations. In this instance the client is generally contacted before the order is confirmed to the person making the query. If the bank is unable to contact the client, it decides how to handle the order on an individual basis taking into consideration the client’s interests. If the client has a bank adviser – which is not always the case for online clients – the adviser often knows the client well and can judge whether the order corresponds to the client’s usual trading behaviour or not. If the order does not match the client’s usual trading behaviour it may be in the client’s interest to cancel the order, for example to avoid any indebtedness.

However, there is no absolute guarantee that the client did not want the order executed this way, in contrast to their usual trading behaviour. In this case, cancelling the order is not in the client’s interest. Any uncertainty could once again be avoided by placing a limit order. BaFin therefore believes that the preferable solution is to prevent a client from placing market orders to buy securities based on an indicative order value calculated on the basis of a PWT.

Several banks have no procedures at all for receiving queries on client orders. Their reasoning for this is that such cases are very rare. This may be the case for the individual institution. However, the market survey has shown that such cases can always arise spontaneously, and that this is not so rare at all. And if the bank does not have any regulated procedure, there is no way of stopping the execution of the order.