TOP STORIES 2012: Exchanges and Regulators Look to Calm Markets

The mandate for exchange operators and regulators in 2013 will be to find ways to calm markets and make sure they operate reliably, even under abnormal conditions. And little wonder: The failure of the BATS IPO, the flubbing of the Facebook IPO, Knight Capital’s runaway algorithm and the two-day shutdown of markets forced by Mother Nature ensure that a repeat string of disruptions will not be healthy.

The effort to calm markets began in 2010, after the flash crash of May 6. New single-stock and marketwide circuit breakers were put in place after that. Stub quotes were eliminated. “Naked access” to exchanges was forbidden. [MGCAP(1)]

In the coming year, the single-stock circuit breakers are giving way to a “limit up/limit down” mechanism. Other antidotes being examined: kill switches, expanded use of drop copies and an auditable trail of all trades.

The “up and down” limits prevent trades in individual stocks from occurring outside a specified price band, above and below the average price of the security in a five-minute period.

For the most highly traded stocks, those in the Standard & Poor’s 500, the Russell 1000 and certain exchange-traded products, the band will be 5 percent above and below the average price. For other listed securities the level will be 10 percent. The percentages will be doubled during the opening and closing periods, and broader price bands will apply to securities priced at $3 per share or less.
The first phase, involving the highly traded stocks, begins Feb. 4. The second phase, for all other stocks, begins on Aug. 5. In certain cases, five-minute trading pauses will be triggered.

Also likely to arrive in 2013 are “kill switches” designed to automatically shut off a firm’s incoming orders, to prevent a market disruption or spate of erroneous orders, like the Knight Capital incident on Aug. 1, 2012.

The exchanges are considering a “layered” approach, whereby a brokerage receives alerts five or 10 minutes before trading is shut off.

But the Securities and Exchange Commission appears to favor a faster response. At a roundtable on market stability in September, chairman Mary L. Schapiro said that, with the speed of automated trading, orders need to be shut off within roughly two minutes to be effective.

And while the brokerage houses themselves will be permitted to determine the thresholds at which the exchanges would cut off their orders, brokerage executives worry those thresholds will be set too liberally to be of any use.

In addition to kill switches, reconciling “drop copy” reports from exchanges on traders is on the radar. Drop copies are sent by exchanges to brokers with details of their most recent trades. Firms reconcile their own trading records against the drop copy information. In the reconciliation process, brokers can identify and eliminate erroneous orders before they pile up. Most, but not all, exchanges deliver the information in real time.

The SEC has taken note of the idea. “[Drop copies] seem like a terrific idea,” said James Burn, a deputy director in the SEC’s Division of Trading and Markets, at a market structure conference in September. “They do seem like a promising safeguard.”

Also coming: a consolidated audit trail of all those trade details. A request for proposals from the effort mandated by the SEC and being carried out by the exchanges and FINRA is expected by mid-December. A technical choice and an implementation are scheduled to be filed with the SEC by April 26.

The central repository of all trading data would be updated nightly, allowing regulators to re-create market activity swiftly and analyze the information for causes of disruptions or abuse.