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September 1, 2010

Traders Digest The 'Clearly Erroneous'

By Peter Chapman

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  • Traders Digest The 'Clearly Erroneous'

Proposals by the exchanges and the Financial Industry Regulatory Authority, introduced in the aftermath of the May 6 "flash crash," to revamp and harmonize their rules covering clearly erroneous trades are being met with mixed reviews.

Andy Kolinsky

Industry professionals praise the self-regulatory organizations for trying to bring clarity and certainty to the process of busting faulty trades, but cite flaws in the details of the proposals. They say variously the proposals go too far, not far enough or are little changed from existing rules. For some, the proposals are just overly complex.

It's "the perfect recipe for mass confusion," Peter Ianello, a partner at a Chicago-based proprietary trading house, told the Securities and Exchange Commission in a letter. The comment period ended July 19.

In the immediate aftermath of the tumult of May 6, which saw the market plummet and rebound in a matter of minutes, some of the exchanges chose to break nearly 21,000 trades they deemed erroneous. The busts, done if the trade was 60 percent or more away from fair value, earned the exchanges the ire of the industry as well as the SEC. Traders complained that the choice of 60 percent was arbitrary and that they should have been informed of the cut-off point in advance.

In response, the SROs have rewritten their rules to bring more certainty and less flexibility to the process of busting trades that get caught up in volatile events such as the flash crash. The rules for busting trades in the wake of these "multi-stock events" of 20 or more names would be grounded in strict numerical guidelines. In addition, exchange officials would lose much of their flexibility to deviate from the numbers.

Under the proposal, the guidelines used depend on whether or not a particular stock is associated with a circuit breaker. As part of their response to the flash crash, the SROs agreed to halt trading in some stocks--those in the S&P 500--if they tripped a circuit breaker, or rose or fell by 10 percent within 5 minutes. Those trades in stocks with associated circuit breakers are busted if their prices diverge from the so-called "Trading Pause Trigger Price" by some amount--either 10 percent, 5 percent or 3 percent. The percentage depends on the price of the stock. Those trades not in the circuit breaker program would be busted if they diverge 30 percent from the last sale or some other reference price.

Prior to the flash crash, the SROs had the ability to deal with volatile events at the opening, but they did not have rules governing other times of the day. The proposed rules govern volatile periods no matter what time they occur.