The Securities and Exchange Commission is scheduled to decide on Thursday whether or not to approve two anti-volatility measures proposed by the nation’s stock exchanges. Up for a vote is a proposal to refine a rule that halts trading in individual securities and one that halts trading in the market as a whole.
The first rule—known as ‘limit up, limit down’—has been on the SEC’s agenda for over a year. The second was proposed last September. Late last year, the SEC decided to consider the two rules together to make sure they didn’t conflict with one another. The SEC has put off making a decision on the two rule changes three times apiece, and could do so again, sources say.
Both rules stem from the events of the May 6, 2010, ‘flash crash’ when the market abruptly flip-flopped. Limit up, limit down is a refinement of the single stock circuit breaker rule that was implemented shortly after the flash crash. The market-wide circuit breaker proposal is a refinement of the 20+ year old circuit breaker rule that sat unused during the flash crash.
Of the two, limit up, limit down is the most anticipated as it is expected to block bad trades before they happen and could lead to a reduction in the number of trading halts. It is considered an improvement over the current regime of single stock circuit breakers which halt trading after bad trades occur.
Still, the industry is wary. The proposal is complex and untried in the U.S. equities markets. Brokerage executives have called on the exchanges to make technical adjustments to the proposal, and have urged the SEC to consider the big picture when making its decision.
“The length of time the Commission has taken does not reflect disagreement over the concept but rather the complexity of the details,” Jamie Brigagliano, a partner at Sidley Austin and a former deputy director of the Division of Trading and Markets at the SEC. “In addition, the Commission wants to harmonize limit up, limit down with any changes to the market-wide circuit breaker rule as well as considering the impact on the futures market.”
Under the existing regime of single stock circuit breakers, trading is halted in a particular security if a stock moves by a relatively large percentage during a rolling five-minute period. For the larger names, trading for $1 or more, that threshold is 10 percent. For the smaller names, it is 30 percent. The rule is in effect between 9:45 and 3:35, so it doesn’t impact the market’s opening and closing.
Under the proposed limit up, limit down scheme, all trades are limited to prices that fall within a given range. For the largest stocks, trading for $1 or more, a trade can take place at a price no more than 5 percent above or below the average price for the preceding 5 minutes. For the rest, the limit is 10 percent. Exchanges and alternative trading systems would be required to block any executions that fall outside this range.
So, not only does limit up, limit down prevent stocks from running too far, too fast, it also largely eliminates “erroneous trades,” those done unintentionally at prices often far removed from reality. Many of the 100 or so trades that triggered circuit breakers last year were deemed erroneous.
Under the proposal, if the market’s best bid touches the upper price limit, or the market’s best offer touches the lower price limit, then trading enters a 15-second limit state. Once the quote is executed in full or cancelled, trading exits the limit state. If that doesn’t happen, trading in the stock is halted for 5 minutes.
Quotes that fall outside the price band become unexecutable. 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.
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 towards a zero defect trading system. 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. A number of industry groups as well as individual brokerages sent letters to the SEC praising the concept, but questioning the mechanics. We present a handful of the criticisms below.
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 SSCBs. 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. Andrew Small, Scottrade’s general counsel, recommended the duration be reduced to 5 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. SIFMA 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, suggest 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 the 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 cancelled 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.
In addition to the myriad qualms the industry has about the limit up, limit down proposal itself, it is also concerned how it will function alongside the market-wide circuit breaker. The rules of that mechanism call for trading to be halted if the Dow Jones Industrial Average drops by a certain percentage. (It does not trigger if the market rises excessively.) The circuit breaker was put in place in 1988, following the Crash of ’87. It is considered outdated, and is getting a makeover.
The revamp stems from the fact that the mechanism didn’t trigger during the flash crash. That’s because the market’s drop was not large enough. The proposal by the nation’s self-regulatory organizations involves a handful of changes, perhaps the most significant being a lowering of the trigger percentages.
While there has been little criticism of the proposed changes themselves, there is concern over the interaction between the market-wide circuit breaker and limit up, limit down. Specifically, should the market-wide circuit breaker trigger if a goodly number of component stocks enter a limit down state or halt?
In a comment letter to the SEC, SIFMA said ‘yes,’ arguing that if too many S&P 500 names go limit down or are halted, then it might prove impossible to calculate the value of the index. CME Group said ‘no,’ arguing such a move would “add even greater complexity or uncertainty” and “would likely impede rather than promote liquidity.”
John D’Antona, Jr. contributed to this story.
