Nasdaq Targets ‘Nefarious’ Circuit Breaker Snafus

Nasdaq OMX, in a bid to remedy the shortcomings of new trading halt rules, is proposing to fine tune them. The exchange operator’s goal is to avoid halts based on trades done by mistake. Such erroneous trades have stopped trading several times this summer.

The new rules, which employ circuit breakers, were put in place on June 10 in the hope of preventing a reoccurrence of the carnage wrought by the May 6 “flash crash.” On that day, hundreds of securities plummeted sharply in a matter of minutes, often executing at ridiculous prices.

Under the circuit breaker rules, Nasdaq and the other exchanges halt trading in any stock in the S&P 500 Index that moves by at least 10 percent in a five-minute period.

Nasdaq’s modification to the circuit breakers was proposed in a letter to the Securities and Exchange Commission last week. Nasdaq wants to only halt trading if the print is in question is inside the NBBO.

If a print falls outside the NBBO, Nasdaq will not immediately halt trading. Instead, the exchange operator will wait until three trades occur outside the NBBO before halting the stock.

Nasdaq proposed the modification because a number of trading halts have been triggered by trades executed in error-so-called “clearly erroneous” trades. A trade that occurs outside the NBBO “is likely an erroneous execution,” Nasdaq told the SEC. Most trades occur within the NBBO, sources tell Traders Magazine.

Since the rule went into effect, several stocks have been halted following these error trades, including Intel, Citigroup, Cisco, the Washington Post Co. and Anadarko Petroleum. Under the rules, stocks are halted for five minutes before being reopened for trading.

Traders have complained that error trades of a few hundred shares should not halt trading in securities that may trade millions of shares per day.

Kevin Cronin, director of global equity trading at Invesco, a money management firm, speaking before the SEC on August 11, criticized “this nefarious problem.” He pointed out to “small trades causing circuit breaker elections and halts in stocks like Cisco and Citigroup that have no business being halted. They’re such small share amounts.”

Cronin’s comments are echoed by others. Dave Cushing, director of global equity trading at Wellington Management Co., told the SEC in a letter last month that the firm questions “whether any single trade, particularly a small erroneous one, should be allowed to trigger a trading halt for a security.”

Despite trader pique, the SEC does not appear overly concerned about the snafus. SEC Chairman Mary Schapiro, speaking at a joint SEC-CFTC investigative hearing on August 11, told panelists that “While we have had a number of triggers, I’d be interested to know if they have caused any harm to the marketplace. It’s not my perception that they have.”

Nasdaq and the other exchanges were aware when they drafted the circuit breaker rules that erroneous trades might trigger halts. They told the SEC, at the time, they would exclude a trade from their circuit breaker calculations if they deemed it erroneous.

That has proved impossible however, as the circuit breaker triggers before an exchange has a chance to review the trade. Thus, Nasdaq’s proposal to automate the process.

Vlad Khandros, in charge of corporate strategy at institutional brokerage Liquidnet, and the firm’s market structure expert, likes Nasdaq’s idea, but would not want to see it implemented unilaterally. “It’s great that exchanges are providing their own ideas,” he said, “but we’d like a uniform set of rules across the market.”

Because the circuit breaker rules are uniform across all exchanges, any change to one exchange’s rule-set likely must be adopted by all the others as well. At this point, Nasdaq’s proposal is in the form of a letter to the SEC. It is not a formal rule filing.

Among the other exchanges, Chris Isaacson, chief operating officer of BATS Exchange, sees the logic in Nasdaq’s idea, but has reservations. He notes, for example, that exchanges receive a number of Intermarket Sweep Orders that trade outside the NBBO. They are not clearly erroneous, but would be ignored under Nasdaq’s proposal.

More to the point, Isaacson and BATS believe circuit breaker-driven trading halt rules should be done away with altogether. They were a fine response to a crisis situation, Isaacson says, by should be replaced with rules that limit price swings, but don’t force a trading halt.

BATS advocates the replacement of circuit breakers with price bands, currently in use in the futures market. The mechanism prevents trades from occurring a certain percentage away from a given reference price. Rather than halt trading once a stock reaches its outer price limit, the price band allows trading to continue but only within the price parameters.

The bands-also referred to as limit up/limit down- would prevent erroneous trades from occurring in the first place, Isaacson explains. 

The current circuit breaker rules are operational as pilots until December 10. They cover the stocks in the S&P 500 Index only. The SEC is now trying to decide whether to expand the rules to cover all of the Russell 1000 stocks, as well as a group of exchange-traded funds and other products.