Proposals by the exchanges and the Financial Industry Regulatory Authority, introduced in the aftermath of the May 6 "flash crash," to revamp and harmonize their rules covering clearly erroneous trades are being met with mixed reviews.
Industry professionals praise the self-regulatory organizations for trying to bring clarity and certainty to the process of busting faulty trades, but cite flaws in the details of the proposals. They say variously the proposals go too far, not far enough or are little changed from existing rules. For some, the proposals are just overly complex.
It’s "the perfect recipe for mass confusion," Peter Ianello, a partner at a Chicago-based proprietary trading house, told the Securities and Exchange Commission in a letter. The comment period ended July 19.
In the immediate aftermath of the tumult of May 6, which saw the market plummet and rebound in a matter of minutes, some of the exchanges chose to break nearly 21,000 trades they deemed erroneous. The busts, done if the trade was 60 percent or more away from fair value, earned the exchanges the ire of the industry as well as the SEC. Traders complained that the choice of 60 percent was arbitrary and that they should have been informed of the cut-off point in advance.
In response, the SROs have rewritten their rules to bring more certainty and less flexibility to the process of busting trades that get caught up in volatile events such as the flash crash. The rules for busting trades in the wake of these "multi-stock events" of 20 or more names would be grounded in strict numerical guidelines. In addition, exchange officials would lose much of their flexibility to deviate from the numbers.
Under the proposal, the guidelines used depend on whether or not a particular stock is associated with a circuit breaker. As part of their response to the flash crash, the SROs agreed to halt trading in some stocks–those in the S&P 500–if they tripped a circuit breaker, or rose or fell by 10 percent within 5 minutes. Those trades in stocks with associated circuit breakers are busted if their prices diverge from the so-called "Trading Pause Trigger Price" by some amount–either 10 percent, 5 percent or 3 percent. The percentage depends on the price of the stock. Those trades not in the circuit breaker program would be busted if they diverge 30 percent from the last sale or some other reference price.
Prior to the flash crash, the SROs had the ability to deal with volatile events at the opening, but they did not have rules governing other times of the day. The proposed rules govern volatile periods no matter what time they occur.
The numerical guidelines work for at least one trading house. "Whenever you remove uncertainty, it’s a positive," Andy Kolinsky, president of Citadel Execution Services, a major wholesaler, told Traders Magazine. "As long as there’s a definitive answer for what is going to happen next time, if there is a next time. Certainty is the key."
Still others contend the guidelines need to be tightened up. The Securities Industry and Financial Markets Association told the SEC the 10-5-3 structure was too generous. Because the percentages would be added to the 10 percent circuit breaker trigger, the end result would be a doubling of the current window. The existing thresholds for clearly erroneous trades are either 10 percent, 5 percent or 3 percent away from the last sale. Again, the percentage depends on the price of the stock. SIFMA recommends replacing the 10-5-3 structure with a more conservative threshold of 2 percent or 5 cents from the trigger price.
In any event, the changes were considered necessary to appease both investors and market makers. Some contend the latter group likely reined in their trading on May 6, thereby contributing to the dearth of bids, over uncertainty whether their trades would stand or not.
Len Amoruso, chief counsel at market maker Knight Capital Group, told a panel of SEC and Commodity Futures Trading Commission officials investigating the causes of the flash crash this summer that "uncertainty around how clearly erroneous trade rules would be applied was likely another contributing factor to the downward spike."
As an example, he noted: "If a liquidity provider purchased 50,000 shares of Proctor and Gamble down 20 percent and sold it before the end of the trading day there was a genuine concern that if the purchase was cancelled under the erroneous trade rules, they could be left short 50,000 shares in a rising market. Thus some liquidity providers may have delayed re-entering the market."
Most trades broken on May 6 were those in exchange-traded funds. BlackRock, the world’s largest money manager with $3 trillion in assets under management, and an adviser to the iShares ETF family, also believes the vagaries of the clearly erroneous rules contributed to the flash crash. BlackRock told the SEC the arbitrary nature of the cancellation process alienated both investors in ETFs as well as market makers. And while the firm is pleased the SROs are revamping the rules, and have eliminated any wiggle room, it is still not happy with the final results.
For those stocks not associated with circuit breakers, BlackRock told the SEC in a letter that the absence of a clearly defined reference price was troubling. The money manager was also bothered by the fact that the time period used to determine if an erroneous trade has occurred is different from the five-minute window used to determine if a multi-stock event has occurred.
"It is not clear to BlackRock that this will provide market participants with significantly greater certainty over trade cancellations than they have today," the firm’s Ira Shapiro said. "The proposed rules do nothing to address the risk that liquidity providers will withdraw liquidity from the market in times of market stress for fear of trade cancellations."
For some liquidity providers, the issue is not just the details of the guidelines, but also the end result. Trading houses such as Knight and Getco, for instance, would rather the SROs adjust the prices of the erroneous trades rather than bust them altogether. "An ‘adjust only’ policy would serve to reduce such instances of widespread position uncertainty," Getco argued in a letter to the SEC.