Safety first as SEC reaches circuit-breaker end-game

Last Friday’s endorsement of new circuit breaker mechanisms by the Securities and Exchange Commission (SEC) – more than two years after the flash crash that prompted a wholesale review of US equity market structure – promises greater safety for investors but some risks remain.

Replacing the single-stock regime imposed by the regulator following the 6 May 2010 flash crash, the new limit up-limit down circuit breaker will, from February 2013, require trades in an individual stock to occur within a price band based on the stock’s average price during the preceding five minutes.

The price band will be 5% for stocks listed in the S&P 500 and Russell 1000 indices and for some exchange-traded products, widening to 10% for other listed securities. The percentages will be doubled during the opening and closing periods and broader price bands will apply to securities priced US$3 per share or less. If a stock goes outside its price band, the new scheme will allow a 15-second window for it to return, but calls a halt to trading for five minutes if the price remains outside its parameters. The new rules will also include a manual override that exchanges can use at their own discretion according to market conditions.

The current circuit breaker regime automatically pauses trading in a stock for five minutes if its price falls by 10% or more in a five-minute period. Although this approach has been criticised for halting trading too often, the SEC has delayed its replacement with the limit up-limit down mechanism several times, due to concerns voiced by market participants about the details of its implementation.

The US watchdog has also updated market-wide circuit breakers that have only been triggered once since they were originally implemented in 1988. The rule changes will reduce the market decline thresholds needed to trigger a circuit breaker, shorten the duration of trading halts, use the S&P 500 rather than the Dow Jones Industrial Average (DJIA) as the price reference and require a daily, instead of quarterly, calibration of trigger thresholds.

The two new circuit breakers will come into effect from 4 February 2013 on a one-year pilot basis.

“Sophisticated, yet workable”

According to the SEC, the events of 6 May 2010, where an unconstrained algorithmic trade sank the DJIA by 9.8% in 20 minutes before it rapidly recovered, led it to assess whether the evolution of US equity market structure required the current market-wide mechanism to be updated.

“The initiatives we approved are the product of a significant effort to devise a sophisticated, yet workable and effective way to protect our markets from excessive volatility," said SEC chairman Mary Schapiro last Friday. “In today’s complex electronic markets, we need an automated and appropriately calibrated way to pause or limit trading if prices move too far too fast.”

The introduction of stock-specific circuit breakers after the flash crash was seen as a complement to the SEC’s decision to ban naked, i.e. unfiltered, access to US stock markets. In November 2010, the SEC unanimously voted in favour of a new rule that would force all trades to pass through risk controls on their way to exchange, but certain aspects of Rule 15c3-5 were not imposed until 12 months later. The implementation of a permanent circuit breaker solution has also proved long and complex.

The SEC had been expected to introduce limit up/limit down in Q3 2011, having outlined a proposal on 25 May 2011. But in January this year, the regulator announced it was extending its consultation following feedback from market participants. Buy-side concerns over the new regime included the impact on exchange-traded funds when some of their constituent underlyings could not be traded, while the sell-side raised objections over additional data costs and the knock-on impact on existing market constraining mechanisms, such as the New York Stock Exchange’s Liquidity Replenishment Points and the alternative uptick rule introduced under Regulation SHO to prevent naked short-selling.   

Market safety

So far, market response to the SEC announcement has been cautiously positive. US broking trade body the Securities Industry and Financial Markets Association (SIFMA) believed the new circuit breakers would help to strengthen US market structure.

“We have been a strong proponent of these approaches since 2010 and believe that these initiatives will contribute to the stability of our markets,” said Randy Snook, executive vice president, SIFMA.

Anticipating SEC approval of limit up-limit down in April 2012, Michael Carrao, head of equity compliance at broker-dealer Knight Capital, told The TRADE that the new process would likely carry out its function with less interruption to liquidity than the existing mechanism.  

“One benefit with the limit up-limit down rule is that it would allow stocks to continuously trade while preventing trading at dislocated prices. This would permit liquidity to flow as a stock approaches its limit up or limit down price,” he said.

Michael Kurzrok, director of equities at capital markets consultancy Woodbine Associates, said the limit up-limit down regime was “better, but not perfect” on account of the 15-second gap ahead of a potential market pause.

“It’s good that the new rule allows 15 seconds for the market to self-correct itself. However if I'm a trader during those 15 seconds and the market ends up halting for that stock, the re-opening could ‘gap’ against me,” said Kurzrok.  

According to Kurzrok, the ability to continue trading a stock in the 15-second window could potentially be detrimental if trading ends up being halted in the security. “After the halt, new buyers can come in and the stock can gap up (or sellers come in and it gap down). If I was a seller (or indeed buyer) before the halt, the gap could be costly,” he said.

The SEC also said it is also still considering whether to approved its proposal for a consolidated audit trail (CAT) that would require exchanges and their members to send quote and order information to a central repository in as close to real time as possible. The CAT was first proposed by the SEC on 27 May 2010.