Commentary: To Be (Uniform) or Not To Be (Uniform)--That is the Question
Traders Magazine Online News, August 11, 2010
On June 10th, each of the national securities exchanges and the Financial Industry Regulatory Authority ("FINRA") adopted uniform market-wide rules for certain securities that experience rapid price movements. These "circuit breakers" reduce abrupt market movements by pausing the trading of any component stock of the S&P 500 Index if the price of that stock moves ten percent or more in the preceding five minute period. This was a direct response to the events of the afternoon of Thursday, May 6, which have come to be known as the "flash crash," when stock prices suffered an unprecedented period of volatility.
Ed Johnsen, Winston & Strawn
In the SEC press release announcing the proposed circuit breakers, Chairman Mary Schapiro was quoted as saying that "[w]e continue to believe that the market disruption of May 6 was exacerbated by disparate trading rules and conventions across the exchanges" and that "it is important that all the exchanges quickly reached consensus." Shortly thereafter, the exchanges and FINRA amended their rules for breaking "clearly erroneous" transactions, bringing greater uniformity to that process. Yet despite these efforts, the landscape is anything but uniform. The market-wide circuit breaker rules and revised "clearly erroneous" standards are a good first step, but some exchanges may be defeating the purpose by layering market-specific price-driven trading pause rules on top of the uniform circuit breakers.
The NYSE and NYSE Amex continue to apply their "Liquidity Replenishment Points" ("LRPs"), first adopted in 2006, which dampen severe price movements resulting from automatic executions by slowing the market and temporarily introducing a manual process. NASDAQ is about to implement its "Volatility Guard," which will trigger a 60-second pause in trading of a security on NASDAQ, but only on NASDAQ, if a trade is executed on NASDAQ at a price beyond a threshold above or below a triggering price. NYSE Arca is proposing market-specific "trading collars" that would prevent market orders from trading more than a certain percentage away from a continuously updated "reference price." Not only are each of these rules distinct from each other, but they operate independently of, and differently from, the market-wide circuit breakers, thus continuing the "disparate trading rules and conventions across the exchanges" that Chairman Schapiro said exacerbated the flash crash. Indeed, a number of commentators have argued that, rather than reducing volatility during times of severe market stress, disparate approaches by individual markets may cause greater volatility if orders end up being routed to less liquid trading centers.
No doubt these exchanges have compelling reasons for imposing additional restrictions. The NYSE claims that the LRPs allowed it to control events on May 6, so that it did not have to break trades. NASDAQ believes that the Volatility Guard is fair, simple, and objective, and will prevent anomalous trades. NYSE Arca states that its trading collars will limit possible damage from severe volatility and help to prevent erroneous trades from triggering the market-wide circuit breakers. The problem is that these rules are likely to be triggered at different times, which could lead to confusion and aggravate volatility as markets effectively remove their liquidity from the marketplace just when it is needed most.
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