The Germans have it. The British have it. The French have it. The Swiss, the Italians and the Japanese all have it. Now the Americans are going to get it.
Next February, the U.S. stock market will start smoothing out the fluctuations in its stocks under a "limit up, limit down" regime. Throughout the day, exchanges will calculate upper and lower price limits for individual securities, and prevent trades from occurring outside those bands.
The limit up/limit down procedure was proposed by the exchanges and the Financial Industry Regulatory Authority in April 2011, and approved by the Securities and Exchange Commission on May 31.
The intent is to prevent spikes in prices-up or down-like those that rattled investors on May 6, 2010, during the "flash crash." Under limit up/limit down, moves in the 1,400 largest securities are capped at 5 percent.
The new system will replace the existing single-stock circuit breaker regime, in effect since the flash crash, which halts trading in stocks if a trade occurs outside of a given price range.
In general, the industry is supportive of limit up/limit down, calling it an improvement over the single-stock circuit breakers, but still harbors concerns over its operation.
"We’re cautiously optimistic," Mike Corrao, chief compliance officer at Knight Capital Markets, told Traders Magazine. "It’s a unique approach that tries to take into consideration the trading characteristics of a security. It forces the industry not to trade when a stock reaches the price where you don’t want it to trade. Theoretically, it’s a smarter test than the single-stock circuit breakers."
Under the circuit breaker system, when a stock reaches a price deemed too high or too low, trading is allowed once, but then halted for five minutes. This methodology is considered flawed by many traders, as individual small trades have halted trading in some of the most active stocks, such as Citigroup, Intel and Cisco.
Still, halts are rare. A study done by Credit Suisse last year found that the circuit breakers were triggered only 111 times during the 18 months between June 2010 and September 2011. Over half the time, the halts were triggered by news-related trades, likely making them justified, said Credit Suisse. Erroneous trades, those caused by order entry mistakes, and thought to be a significant problem, triggered halts in only 17 percent of the cases.
The new system is expected to block bad trades before they happen, rather than after. Under the scheme, trading halts can still occur, but are expected to do so less frequently. Like the single-stock circuit breakers, limit up/limit down prevents stocks from running too far, too fast. But it also largely eliminates "erroneous" trades, or those done unintentionally at prices often far removed from reality. Exchanges consider trades to be "clearly erroneous" if they occur outside certain predetermined price limits. Typically, these trades happen because of typographical errors or careless order entry.
Still, the industry is wary. The proposal is complex and untried in the large and sprawling U.S. equities market. Earlier, brokerage executives called on the exchanges to make technical adjustments to the plan and urged the SEC to consider the big picture when making its decision.
"Our concern is the retail trader," explained Corrao. "It’s easy for them to understand a trading halt. But it will be much more difficult for them to understand it when their broker tells them, ‘We can’t take your order at that limit because it would cross the threshold price and you wouldn’t be able to get it executed until the threshold price moves through your limit.’ Educating the retail customer will be a challenge."
With the single-stock circuit breakers, trading is halted in a particular security if at least three prints deviate by at least 10 percent over the last sale during any five-minute period. The rule is in effect between 9:45 and 3:35, so it doesn’t impact the market’s critical opening and closing periods.
By contrast, limit up/limit down is in effect all day. Under the system, trading is not immediately halted after an "event"; rather, it is contained within a price range. The limit state ends (and normal trading resumes) if all quotes are extinguished within 15 seconds. If not, trading is halted for five minutes.
(In Europe, there is no limit state. Once a limit is touched, trading is halted for a few minutes to allow for an auction.)
Unlike the halts under the single-stock circuit breaker regime, which are triggered by trades, the limit state under limit up/limit down is triggered by orders or quotes. Trading enters a limit state if the market’s best quotes touch either the upper or lower price limits.
The limits themselves are still determined by the last sale (or an average over the previous five minutes). For those large-cap names trading for at least $3, the threshold is 5 percent above or below the average. For the rest, the limit is either 10 or 20 percent.
Quotes that fall outside the price band cannot be executed. They may or may not be displayed. If the market’s best bid falls below the lower price limit, for example, it is displayed but can’t be traded against. If the market’s best bid exceeds the upper limit, it is not displayed (see graphic).
At the last minute, the exchanges augmented their rules for bids that fall below the lower limit and offers that breach the upper limit. In the final rule, this scenario is defined as a "straddle state." It gives the exchanges the right to halt trading in the stock if the market for the stock "deviates from normal trading characteristics." The change proved controversial, as limit up/limit down is intended to reduce the number of outright halts.
All of this is extremely complicated, says one longtime observer of market structure, but still necessary. "We need to prevent erroneous trades rather than bust them," Jim Angel, an associate professor in the McDonough School of Business at Georgetown University, told Traders Magazine.
"We need a market mechanism that won’t allow bad trades to occur in the first place. We need to move toward a zero-defect trading system," he said. "Think of it like the quality-control mechanisms we’ve seen in American manufacturing in the last couple of decades. Instead of tolerating a bad car that you bring in for warranty repairs, manufacture it right the first time."
Most of the industry supports the idea of limit up/limit down, but many have qualms about some of the details. During the comment period, a number of industry groups and individual brokerages sent letters to the SEC praising the concept but questioning the mechanics. The exchanges addressed some of their concerns, but not all. Outstanding criticisms are:
Overly complex reference price
The upper and lower levels of the price band are derived from a continuously updated reference price, defined as the mean of reported trades over the preceding five minutes. Professor Angel and some trading executives told the SEC that such a dynamic reference price may be too complex. They suggest using a static reference price based on the day’s opening price or the closing price from the previous day.
Too many circuit breakers
A new limit up/limit down mechanism would become part of the operations of all exchanges. It would replace the existing single-stock circuit breakers. At least two exchanges, however-the New York Stock Exchange and NYSE MKT-currently operate proprietary mechanisms alongside their circuit breakers. Some trading officials contend an exchange should only operate a single anti-volatility mechanism. The SEC itself stated in a March 2011 regulatory filing that it might someday find "exchange-specific volatility moderators" to be inconsistent with the Securities Exchange Act of 1934.
Limit state is too long; limit state is too short
Some trading officials told the SEC that a 15-second limit state was too long. Others maintain it may be too short. Scottrade general counsel Andrew Small recommended the duration be reduced to five seconds. The retail broker’s fear is that a customer would trade a stock during the lengthy limit period when the price of the stock is being artificially held up or kept down. Then, when the limit period expires, the stock moves sharply, catching the customer unawares. The Securities Industry and Financial Markets Association also contends that 15 seconds is too long. Because market makers can refresh their quotes very quickly, SIFMA believes a limit state is unlikely to last more than one second. Vanguard, on the other hand, suggests that a 15-second limit state might be too short and could lead to too many halts.
Trouble at the opening and closing
Many trading execs are concerned that halts could disrupt trading during the critical opening and closing periods. That’s despite the fact that, under the proposal, the upper and lower limits of the price band would double in the first 15 minutes of trading and the last 25 minutes. Knight Capital Group, for its part, believes that limit up/limit down should not operate during both the first five minutes of trading and the last five minutes. Execs from both Investment Technology Group and Scottrade recommend eliminating halts in the final 10 minutes of the day. ITG’s Jamie Selway would prefer that halts be canceled for the entire final 25 minutes of the day.
Too rigid for less liquid securities
The limit up/limit down proposal applies to National Market System (exchange-listed) securities. It divides this universe into two tiers. Tier 1 securities consist of the component stocks in the S&P 500 Index, the Russell 1000 Index and about 350 exchange-traded funds. Tier 2 securities are all the rest. The price band for the former, if trading for $1 or more, is 5 percent on either side of the reference price. For the latter, it’s 10 percent. At least one firm-Knight-believes there should be a third tier encompassing low-volume stocks with spreads that are wider than the proposed bands. The SROs did decide to exclude warrants and rights. They also amended their original proposal to include a third band for low-prices stocks, or those trading between $1 and $3. The threshold is 20 percent in this case.
The problem of quotes outside the bands
Offers that fall below the lower price band and bids that exceed the upper price band will not be displayed. Some players argued that not displaying them would hurt traders ability to assess the total liquidity in a security. The exchanges disagreed, saying their display would risk investor confusion. Also, some players suggested that limit states should be triggered by quotes that fall outside the band, not just those inside the band. The exchanges may reconsider this point.
