On June 10th, each of the national securities exchanges and the Financial Industry Regulatory Authority ("FINRA") adopted uniform market-wide rules for certain securities that experience rapid price movements. These "circuit breakers" reduce abrupt market movements by pausing the trading of any component stock of the S&P 500 Index if the price of that stock moves ten percent or more in the preceding five minute period. This was a direct response to the events of the afternoon of Thursday, May 6, which have come to be known as the "flash crash," when stock prices suffered an unprecedented period of volatility.
In the SEC press release announcing the proposed circuit breakers, Chairman Mary Schapiro was quoted as saying that "[w]e continue to believe that the market disruption of May 6 was exacerbated by disparate trading rules and conventions across the exchanges" and that "it is important that all the exchanges quickly reached consensus." Shortly thereafter, the exchanges and FINRA amended their rules for breaking "clearly erroneous" transactions, bringing greater uniformity to that process. Yet despite these efforts, the landscape is anything but uniform. The market-wide circuit breaker rules and revised "clearly erroneous" standards are a good first step, but some exchanges may be defeating the purpose by layering market-specific price-driven trading pause rules on top of the uniform circuit breakers.
The NYSE and NYSE Amex continue to apply their "Liquidity Replenishment Points" ("LRPs"), first adopted in 2006, which dampen severe price movements resulting from automatic executions by slowing the market and temporarily introducing a manual process. NASDAQ is about to implement its "Volatility Guard," which will trigger a 60-second pause in trading of a security on NASDAQ, but only on NASDAQ, if a trade is executed on NASDAQ at a price beyond a threshold above or below a triggering price. NYSE Arca is proposing market-specific "trading collars" that would prevent market orders from trading more than a certain percentage away from a continuously updated "reference price." Not only are each of these rules distinct from each other, but they operate independently of, and differently from, the market-wide circuit breakers, thus continuing the "disparate trading rules and conventions across the exchanges" that Chairman Schapiro said exacerbated the flash crash. Indeed, a number of commentators have argued that, rather than reducing volatility during times of severe market stress, disparate approaches by individual markets may cause greater volatility if orders end up being routed to less liquid trading centers.
No doubt these exchanges have compelling reasons for imposing additional restrictions. The NYSE claims that the LRPs allowed it to control events on May 6, so that it did not have to break trades. NASDAQ believes that the Volatility Guard is fair, simple, and objective, and will prevent anomalous trades. NYSE Arca states that its trading collars will limit possible damage from severe volatility and help to prevent erroneous trades from triggering the market-wide circuit breakers. The problem is that these rules are likely to be triggered at different times, which could lead to confusion and aggravate volatility as markets effectively remove their liquidity from the marketplace just when it is needed most.
The negative impact of these disparate rules on market participants could be considerable, and the cost and complexity of conforming trading practices and systems to comply with them may well outweigh their benefit. For example, broker-dealer order management systems will have to be programmed to respond to multiple trading halt triggers, the application of which will be dependent on the particular market to which each order has been sent. Disparate trading pause rules also can raise difficult best execution issues, as firms determine what to do with orders directed to a market where a halt has been triggered. If another market continues to trade the security, should (or must) the broker-dealer cancel the order at the halted market? Should orders be directed to the halted market in hopes of getting a better execution when that market reopens? Indeed, should orders be cancelled at non-halted markets because there is evidence of possible price discrepancies?
And it’s not just broker-dealers who could be negatively affected. Multiple non-uniform trading pauses also create a risk of confusion and disruption among investors. Sophisticated investors relying on sponsored access arrangements and sophisticated order management systems face the same issues as broker-dealers in trying to conform systems and procedures to multiple rules that address the same situation, in the same security, at the same time, but in different ways. Unsophisticated investors may have trouble "reading the tea leaves" when one market halts trading because of volatility concerns while others continue to trade.
Ultimately, it may turn out that circuit breakers are not the best approach. Many have suggested alternative methods to dampen volatility, including "Limit Up/Limit Down Restrictions" similar to those used in the futures markets (and the collars proposed by NYSE Arca), which permit trading only within established price bands. This allows trading to continue in periods of extreme volatility, and can prevent the execution of clearly erroneous trades rather than having to break them after the fact. But whether it is circuit breakers, trading limits, or something else, uniformity in approach will be essential to successfully implementing the kind of market-wide regime that successfully controls dangerously excessive volatility in a reasonable, rational fashion.
Since the adoption of Regulation NMS, the equity markets have become so interconnected that multiple, disparate, market-specific rules to address the same situation in the same security are largely untenable. Notwithstanding the legitimate concerns of individual exchanges in protecting their issuers, markets, and market participants, uniformity of trading rules is critical. In times of market stress, if each market trading the same security has different parameters for determining whether to trade normally, modify trading, or halt trading altogether, the decision of how to react is exponentially more difficult, creating a significant risk of widespread confusion at a time when clear, simple and consistent guidelines are of the utmost importance.
Edward Johnsen is a partner in the New York office of Winston & Strawn LLP. Mr. Johnsen concentrates his practice on regulatory matters relating to broker-dealers and other financial institutions. Michael DiFiore is an associate in the Corporate Department of Winston & Strawn’s New York office.
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com
