The Securities and Exchange Commission is expected to approve today two proposals by the nation’s exchanges intended to dampen volatility in the stock market.
The first is the so-called ‘limit up, limit down’ mechanism for individual securities that will confine trades to a pre-determined price range. It replaces an existing system that halts trading when stocks trade outside a given price range.
The second is a proposal to revise a mechanism that halts trading in all stocks. This market-wide circuit breaker has been in effect since 1988 and triggers when the market drops by a certain percentage.
Both changes stem from the events of the May 6, 2010, ‘flash crash,’ when the market abruptly flip-flopped. The crash jolted the industry and its regulators to call for the single stock circuit breakers and a revamp of the market-wide circuit breaker, which did not trigger that day.
In general, the industry supports the new mechanisms, but still harbors concerns over their operation, especially that of limit up, limit down.
"We’re cautiously optimistic," Mike Corrao, chief compliance officer at Knight Capital Markets, told Traders Magazine, in reference to limit up, limit down. "It’s a unique approach that tries to take into consideration the trading characteristics of a security. It forces the industry not to trade when a stock reaches the price where you don’t want it to trade. Theoretically, it’s a smarter test than the single-stock circuit breakers."
The SEC would not comment.
Limit up, limit down was first proposed in April 2011. The SEC received several comment letters from industry players—many expressing concern over the complexity of the rule. The exchanges rejected most concerns, but did incorporate some changes to an amended proposal last week.
Those include working with an advisory committee consisting of representatives from three brokers and one money manager; exceptions for certain institutional orders; and the exclusion of rights and warrants from the rule.
The exchanges also incorporated special parameters for low-priced stocks, or those trading for less than $3. They also gave themselves the right to halt trading in a stock under certain circumstances if they deem it necessary.
This last minute addition is perhaps the most controversial as limit up, limit down is intended to reduce the number of outright halts.
Under the original proposal, if the best bid, for example, falls below the lower range of the price band, the quote is displayed, but is not executable. Under the amended proposal, this scenario is defined as a "straddle state," giving the exchanges the right to halt trading in the stock if the market for the stock "deviates from normal trading characteristics."
The new discretion concerns Knight. "Will they be consistent? When is it going to happen? What would they consider abnormal situations?" Corrao questioned. "I’m okay with it as long as it’s done in a manner that makes sense. But they’ve written it in a way that gives them so much flexibility, I’m unable to say whether they will do it in a manner that makes sense."
Under the amended proposal, limit up, limit down would go into effect next February. (For more details, please see May 29 article entitled Circuit Breaker Deadline Looms.)
