Traders are going to have to get used to the single-stock circuit breakers put into effect shortly after the May 6 flash crash, because any replacement is still on the drawing board.
While the single-stock circuit breakers–SSCBs–have been praised for being easy to implement and for their effectiveness at slowing rapidly rising or falling securities, they have been criticized for going off too regularly.
Relatively small erroneous prints have been triggering five-minute trading halts in such actively traded names as Citigroup, much to the consternation of traders. Trading executives have touted so-called collars, or price bands, as superior substitutes, but there is still much debate over how to incorporate them into the market.
Exchange executives at first predicted rapid implementation of an alternative to SSCBs, but now brokerage executives are weighing in with concerns and ideas. The back-and-forth means implementation by early 2011, as was originally predicted, is unlikely.
"I think we have a long way to go before we end up with a rule," Shane Swanson said at the fifth annual Futures Industry Association/Options Industry Conference on Oct. 5 in New York. "And then whatever that rule is, I think we have a long way to go before we actually implement it."
A limit up/limit down, or price band, mechanism is used in the futures market. It limits trades to prices around a given reference price, such as the previous day’s closing price. Trades inside the band are allowed; those outside the band are rejected.
This represents a stark contrast to how SSCBs operate in the equities market. They are designed to stop exchange trading altogether for any stock in the S&P 500 index, Russell 1000 index and select exchange-traded funds that moves by at least 10 percent in a five-minute period.
Most in the market agree that a remedy to the current circuit breakers is needed. Proponents of limit up/limit down, such as the exchanges, point out that it prevents erroneous trades from occurring, such as on May 6, when around 20,000 such trades were canceled. Limits would reject all orders posted outside the price band. In addition, limit up/limit down would keep the markets open and let trading and price discovery continue.
Still, some in the industry see a role for both circuit breakers and price bands. In an Oct. 12 comment letter to the Securities and Exchange Commission, the Securities Industry and Financial Markets Association advocated a hybrid mechanism. It would contain three key elements: limit up/limit down protection, a request for liquidity and, where necessary, trading halts.
Price bands would prevent trades from occurring outside acceptable predetermined price ranges. These ranges would be calculated and disseminated to all market participants on a periodic intraday basis.
A bid/offer wanted period would establish a mechanism for alerting market participants to the need for additional liquidity within the acceptable price range to avoid unnecessary price swings.
With such a hybrid mechanism in place, SIFMA said, trading would only be permitted within a specified uniform, marketwide, acceptable price range, such as 10 percent up and down of the trailing 10-minute volume-weighted average price for the security.
For example, a stock trading at $10 a share would have a VWAP price band of $9 to $11. If a sell order for 100,000 shares enters the market with only 70,000 shares executed, the price hits the $9 limit, and the remaining 30,000 shares will be posted at the $9 limit. At this point, all markets and trading centers are alerted the limit has been hit. To generate a bid, trading is slowed at the limit price for five seconds or until a supportive bid surfaces. This allows trading to continue and maintains liquidity. If no bid surfaces, the single-stock circuit breaker applies, and a trading halt occurs for five minutes.
Unlike in the futures market, however, trading execs say, implementation in the stock market presents challenges because of two major differences between the two. First, in the futures market, a given instrument only trades on one exchange, the Chicago Mercantile Exchange. In the equities market, securities can and do trade on more than a dozen exchanges. Second, there is no off-board trading in the futures market. There is in equities.
However, using price bands or limits in the equities markets might be more difficult, said Joe Mecane, executive vice president and chief administrative officer for U.S. markets at NYSE Euronext at a recent conference. Internalization doesn’t occur in the futures markets, but it is common in the equities markets, posing a problem, he added.
Mecane broached the topic at this year’s Security Traders Association conference. The problem, as he sees it, is: At what price do the internalizers print their incoming retail orders when a stock is at the limit price?
"Do they get printed at those limit up/limit down prices if there is the potential for those prices to move a few minutes later?" he asked. "It’s probably solvable, but people need to think about it."
As for fragmentation, Mecane noted there will be problems in implementing a uniform policy across exchanges that deals with such issues as where and at what price to reopen a stock after trading in a band.
"Whether it is single-stock circuit breakers or limits, the general concept is: How do you aggregate liquidity, so that if you do end up in a situation where liquidity is pulling off to different venues and there isn’t as much to go around, rather than have multiple venues trading with no depth, do you have a better market where you aggregate liquidity into one place?" he said.
Bryan Harkins, head of sales and strategy at Direct Edge, also urges caution when it comes to implementing limit up/limit down.
"This is a more complicated implementation than was the case with trading halts," he said. "Trading halts were nothing new to the market … a halt message gets disseminated through the SIP just as it always has, and when market centers receive that message, they cease executing in that security. Limit up/limit down is different and poses greater potential implementation challenges to internalizers and ATSs, in many respects more so than for exchanges. There are nuances here that will need to be fully thought through."
Still, despite the challenges, most execs are optimistic.
"By this time next year, we’ll be living in a world with limit up/limit down," said Chris Concannon, partner at Virtu Financial, an electronic market-making firm.
