Exchanges Prepared to Set Up ‘Kill Switches’

NYSE Euronext, NASDAQ, BATS and Direct Edge say they are prepared to set up limits on the amount of trading their members conduct in a given trading session and shut them down if they exceed pre-set peaks.

The trigger mechanism was spelled out in a comment letter submitted Friday morning to the Securities and Exchange Commission.

The letter was submitted in advance of Tuesday’s SEC roundtable on market stability, called after waves of erroneous orders from market maker Knight Capital flooded national exchanges on August 1. The exchange-run controls would act as ‘kill switches’ on unusually high order or trade volume.

The controls are the prime proposal of a series of possible answers to “significant unintended market activity” suggested by a combination of exchanges, brokers, institutions and the Financial Industry Regulatory Authority that formed an industry working group after the disruption that nearly caused the demise of Knight Capital, one of the leading market makers on the New York Stock Exchange and other venues.

The working group includes Bank of America Merrill Lynch, Citadel, Citigroup Global Markets, Deutsche Bank Securities, GETCO, Goldman, Sachs & Co., IMC Chicago, ITG, Jane Street, Morgan Securities, RBC Capital Markets, RGM Advisors, Two Sigma Securities, UBS Securities, Virtu Financial and Wells Fargo Securities.

The letter is signed by NYSE Euronext, Nasdaq OMX, BATS Global Markets, Direct Edge, the Chicago Stock Exchange, FINRA and the Depository Trust & Clearing Corporation, the industry’s post-trade utility.

Triggering a potential shut down of abnormal activity would be a metric called “Peak Net Notional Exposure.’’

This calculation would place limits on the overall activity of a member firm and, “if the firm breaches its set limit, the SRO would shut down the trading session,’’ according to the letter submitted by the exchanges, FINRA and DTCC to the SEC Friday.

Here is how the ‘kill switch’ would work.

Exchanges would establish and maintain controls that track the “peak net notional exposure” of a market maker, brokerage, trading firm or other member firm, throughout a trading day.

Limits would be set for the total financial exposure taken on each day by a market participant. Long or short positions, or combination long and short positions, would each count against the total exposure taken on. Going long $600 on one stock and $400 short on another, for instance, would count as $1,000 “net” exposure.

The caps would be designed to spot excessive market activity, such as occurred on August 1. When a firm hit its limit, the exchanges would send out an alert. If the peak is exceeded, the exchange would shut down trading by the member firm.

The caps could be adjusted, so that they rose, or fell, in relation to the amount of overall trading volume occurring on a given day on a given exchange.

Faster ‘kill switches’ are needed to prevent market disruptions such as the August 1 flood of erroneous orders from market maker Knight Capital, the head of FINRA said last week at the Security Traders Association meeting in Washington, D.C.

”Kill switches have to be far more hair-triggered than they have been in the past,’’ chief executive Richard Ketchum said.