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September 1, 2011

CME Slams Limit Up/Limit Down Plan

By Peter Chapman

CME Group says a proposed limit up/limit down plan for stocks and exchange-traded products is bad market structure.

The operator of four futures exchanges told the Securities and Exchange Commission in a June letter that a plan to prevent price spikes in individual securities would do more harm than good. CME wants the regulator to nix the proposal by the Financial Industry Regulatory Authority and the nation's stock exchanges and consider a plan of CME's.

The self-regulatory organizations' proposal "sets forth an overly complicated and insufficiently coordinated structure," CME chief executive Craig Donohue told the SEC. "In a macro-liquidity event, [it] will have the unintended consequence of undermining rather than promoting liquidity."

The SROs' proposal is a refinement of the existing single-stock circuit breaker mechanism put in place after last year's "flash crash," during which several stocks dropped precipitously and then rebounded. The idea is to dynamically apply price bands around stocks and exchange-traded products and limit trading to within those bands for 15 seconds. If the liquidity condition does not improve, then trading is halted for five minutes.

CME, which trades futures on equity indexes as well as options on those futures, maintains the plan could halt trading in index-based ETFs without regard to futures and options traded on those indexes. The plan also does not coordinate a halt in trading of an ETF with the market-wide circuit breakers based on the Dow Jones Industrial Average.

In addition, CME charged, the limit up/limit down proposal could halt trading in the individual components of those indexes, which could make it difficult to calculate index values, thereby disrupting trading in futures markets.

Rather than continue to support circuit breakers on individual securities, CME contends that the SROs should do away with them and simply make adjustments to existing marketwide circuit breakers. (CME already bases trading halts in index futures and options on the parameters of the stock exchanges' marketwide halts.)

CME does support the use of trading pauses of individual securities, but for very short durations, such as five seconds. The exchange operator notes that its "stop logic" pauses trading for five to 20 seconds, depending on the contract and time of day. In the heavily traded E-mini S&P 500 futures contracts, for example, CME halts trading for five seconds if the price spikes outside predefined thresholds.

The stock trading industry has largely embraced the limit up/limit down plan, albeit with qualifications. But at least one observer contends that CME has a valid point.

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"There needs to be some sort of coordination with the futures and options markets," said Steve Nelson, principal at the Nelson Law Firm and an attorney for the New York chapter of the Security Traders Association. "The problem is that the SEC doesn't regulate futures and none of the SROs that created those rules operates those markets."

One of the main features of the SROs' limit up/limit down plan is a 15-second limit period when trading is restricted to prices within a 5 or 10 percent band around the last sale. This was added to the circuit breaker mechanism to prevent the possibility of a botched order getting filled and triggering a five-minute trading halt. To address the issue of such erroneous orders, CME favors the use of price bands and order quantity limits, it told the SEC.


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