The trading community likes the proposed limit up/limit down rule, but still has quibbles. In April, the securities exchanges and the Financial Industry Regulatory Authority proposed a reworking of the trading halt mechanism put in place after last year’s "flash crash." As Traders Magazine was going to press, comment letters began streaming into the Securities and Exchange Commission, which must approve the proposal.
The response from traders is largely positive. "The trading community did not like the individual circuit breakers," said Steve Nelson, founder of the Nelson Law Firm and an attorney for the New York chapter of the Security Traders Association. "Limit up/limit down is seen as an improvement over that system."
See Sidebar: Options Industry
Under the current circuit-breaker regime, trading in a stock is halted for five minutes if the price rises or falls by 10 percent or more during any five-minute period. The goal is to reduce volatility by allowing the market to "catch its breath" and find the natural level of the stock’s price.
Traders aren’t crazy about the mechanism, however, because halts can be triggered by so-called "erroneous" trades, those done at prices far removed from the national best bid or offer. In the year or so since the individual stock circuit breakers were implemented, several stocks have been halted needlessly, including some very active names, such as Citicorp.
Formally known as the "Plan to Address Extraordinary Market Volatility," the limit up/limit down proposal seeks to improve upon the original. First, it is designed to prevent erroneous trades from occurring. Second, it seeks to avoid a trading halt by introducing a 15-second "limit state" of continuous trading before any halt can occur. The limit up/limit down proposal is modeled after a similar scheme used in the futures market, but is more complex.
The SEC published the proposal in the Federal Register on May 25. After a 21-day comment period, it intended to determine whether or not to approve the rule, the commission wrote in a press release. As of mid-July, the SEC had not made a decision. The major points of the proposal and criticisms follow.
Price Bands
A price band is calculated and disseminated by the Securities Industry Processors (exchanges) on a continual basis throughout the day. It is based on a reference price, calculated as the average of the last sale during the preceding five minutes. For the largest stocks, the upper limit of the band is 5 percent over the reference price. The lower limit is 5 percent below the reference price. For smaller stocks trading at over $1.00, the limits are 10 percent away from the reference price. Orders that fall outside these bands are rejected by the exchanges. That eliminates the possibility of erroneous trades.
Limit State
Trading enters a "limit state" if the market’s best bid rises to the upper limit or the market’s best offer falls to the lower limit. As proposed, the limit state lasts 15 seconds. The hope is that new orders will enter the market during this period that propel the stock away from-but still within-the limits. If all the quotes at the limit price are executed or canceled during the 15 seconds, trading resumes. If no trades occur during this period, trading is halted for five minutes.
The Halt
Quotes are published, but no trading occurs during this five-minute period. The primary market-that which lists the security-will reopen trading in the stock after the halt. Trading will resume even if there is a large order imbalance.
Criticism No. 1: Plan Is Too Complicated
Limit up/limit down is used in the futures market. The schema there, however, is simpler. The futures exchanges base their limit prices on the previous day’s close. They also halt trading for the rest of the day if a limit is reached. Some commenters suggested this simpler model might be more appropriate for the stock market. Others suggested that any limit up/limit down model is too complex to impose on the stock market and might confuse retail investors. "We are concerned about introducing an unknown level of complexity to the equity market micro-structure," Len Amoruso, general counsel at Knight Capital Group, told the SEC in a letter.
Criticism No. 2: Limit State Is Too Long
The Securities Industry and Financial Markets Association argued that the proposed limit state is too long. The trade association representing broker-dealers would like to see it reduced from 15 seconds to five seconds. "The purpose of the limit state is to allow liquidity providers to refresh their quotations," SIFMA told the SEC. "In today’s electronic markets, it takes significantly less than 15 seconds for liquidity providers to update their quotations." SIFMA believes that most limit states will end after only one second. SIFMA is concerned that an overly long limit state will cause uncertainty for traders, especially options traders (see sidebar).
Criticism No. 3: Limit State Is Too Short
One advocate for the buyside argued that a limit state of 15 seconds is too short and won’t give traders enough time to participate. "Our members report that 15 seconds is not a sufficient amount of time for most investors to digest information about a limit state condition and to react to the information," the Investment Company Institute told the SEC. The organization wants the limit state expanded to 30 seconds. Money manager Vanguard agrees with the ICI. Vanguard chief investment officer Gus Sauter worries that an overly short limit state will "lead to an unnecessary number of trading halts."
Criticism No. 4: Institutional Trades Should Be Exempt
Some institutional traders would like exemptions for block trades, benchmark trades such as VWAPs, qualified contingent trades, and stopped orders. SIFMA argues that trades that do not impact last sale prices should be excluded. Under the rule, only trades that update the last sale price are used in calculating the reference price. SIFMA points out in its comment letter that VWAP trades do not affect the last sale. Therefore, they do not contribute to market volatility. So they should be permitted at prices outside the band. Deutsche Bank’s comments echo those of SIFMA. "These trades do not pose the risk of destabilization even if the executions occur outside the price bands," Jose Marques, Deutsche Bank’s global head of electronic equity trading, told the SEC. The exec also argues that block trades should be exempt. "They tend to be stabilizing to the market, as the block positioner is committing capital to absorb large trading interest that would otherwise impact the market."
Criticism No. 5: The Close
Limit up/limit down is to be implemented during a yearlong pilot in two phases. During the first phase, the rule would not be applied during the first 15 minutes of trading and the last 30 minutes. During the second phase, starting six months in, the price bands and halts would be in effect all day. The price bands during the opening and closing periods will be doubled, however. Still, many traders are worried about the impact on the close once phase two kicks in-trading is very active during the final 30 minutes of the day. SIFMA told the SEC that the first 15 minutes and the final 30 minutes of the trading day should not ever be subject to the rule. "Given that liquidity is often highest at or around the close of trading, we believe that continuous trading should be permitted for some period of time prior to the close," SIFMA said. Agency brokerage Investment Technology Group concurred. "A trading pause initiated during the last 25 minutes of regular trading hours could disrupt price discovery into the close, thereby creating excessive price volatility upon re-opening," ITG managing director Jamie Selway told the SEC.
Criticism No. 6: Too Many Circuit Breakers
Once the limit up/limit down proposal is implemented, there will be four sets of circuit breakers in the market. The proposed mechanism would replace the existing single-stock circuit breakers. The others are the New York Stock Exchange’s Liquidity Replenishment Points; the Reg SHO circuit breakers; and the marketwide circuit breakers. (In June, Nasdaq halted plans to introduce its Volatility Guard in deference to the limit up/limit down plan.) Some traders told the SEC they would feel more comfortable if the marketplace only used one set of circuit breakers: those in the proposal. The New York chapter of the Security Traders Association told the SEC that "the simultaneous triggering of two or more of these speed bumps during times of heightened market volatility could cause confusion and uncertainty unless there is a scheme in place for handling multiple triggers." Of the three other circuit breakers, the one most traders would like to see jettisoned is the NYSE’s LRP. In the past, the NYSE has indicated it did not wish to decommission its circuit breakers.
Criticism No. 7: Price Bands for Low-Priced Stocks
For the largest 1,000 or so National Market System stocks, the price bands are set at 5 percent on either side of the reference price. For all the rest of the stocks trading at over $1.00, the bands are set at 10 percent. Some traders note that many stocks have spreads of 10 percent or more. Therefore, a 10 percent band would be unworkable. These stocks need higher band percentages, traders contend. "Low-volume stocks present challenges where displayed spreads exceed the 10 percent band," Stuart Kaswell, general counsel for the Managed Funds Association, told the SEC. "For such a stock the opposite quote would become non-executable after a trade." Knight’s Amoruso concurred. He recommends the SEC consider a third tier based on average daily volume.
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