US Stock Exchanges Address 'Flash Crash' Risks
Monday, April 11, 2011

The Securities and Exchange Commission (SEC) has announced that several United States stock exchanges, including NYSE Euronext, Chicago and Nasdaq, together with the Financial Industry Regulatory Authority (FINRA) have filed a proposal to establish a new ‘limit up-limit down’ mechanism to address extraordinary market volatility in US equity markets.

Under the proposal, trades in listed stocks would have to be executed within a range tied to recent prices for that security. If approved by the Commission, the new ‘limit up-limit down’ mechanism would replace the existing single stock circuit breakers, which were approved on a pilot basis shortly after the market events of May 6, 2010.

The 'Flash Crash,' as it is called, of May 6 last year, was an extreme movement in the prices of many US-based equity products that experienced an extraordinarily rapid decline and recovery. For example, it was the biggest point decline on an intraday basis, almost 1,000 points, in the Dow Jones Industrial Average’s history.

The proposed ‘limit up-limit down’ mechanism would prevent trades in listed equity securities from occurring outside of a specified price band, which would be set at a percentage level above and below the average price of the security over the immediately preceding five-minute period. For stocks currently subject to the circuit breaker pilot, the percentage would be 5%, and for those not subject to the pilot, the percentage would be 10%.

The percentage bands would be doubled during the opening and closing periods. To accommodate more fundamental price moves, there would be a five-minute trading pause – similar to the pause triggered by the current circuit breakers – if trading is unable to occur within the price band for more than 15 seconds.

If approved, all trading centres, including exchanges, and broker-dealers executing internally, would have to establish policies and procedures reasonably designed to prevent trades from occurring outside the applicable price bands. The exchanges and FINRA have requested that the SEC approve the plan as a one-year pilot program.

“Upgrading our trading parameters will help our markets retain the confidence of investors and companies,” said SEC Chairman Mary L. Schapiro. “We were focused on improving the structure of our markets before weaknesses were exposed on May 6, and we will continue to be focused on market structure going forward.”

Under the existing circuit breaker pilot, trading in a stock pauses across the US equity markets for a five-minute period if the stock experiences a 10% change in price over the preceding five minutes. The pause gives the markets the opportunity to attract new trading interest in an affected stock, establish a reasonable market price, and resume trading in a fair and orderly fashion.

The circuit breaker pilot was initially approved by the SEC in June last year, and is currently set to expire on August 11, 2011 (or earlier if the ‘limit up-limit down’ mechanism is implemented before then). The circuit breakers apply to securities in the S&P 500 Index and Russell 1000 Index, as well as to certain exchange-traded funds.

However, it has been seen that, while the circuit breakers have been effective in moderating potentially extraordinary volatility, they also have been triggered by erroneous trades. As a result, Schapiro has encouraged the exchanges and FINRA to develop a more sophisticated mechanism that not only would prevent an erroneous trade from triggering a trading pause, but keep the erroneous trade from occurring in the first place.

“The circuit breakers for individual securities across the exchanges helped to limit significant volatility and bring uniformity to decisions regarding trading halts in individual stocks,” added Chairman Schapiro. “But we felt that we could improve upon the system, and have been working with the exchanges and FINRA since the adoption of the single-stock circuit breaker pilot program to develop improved mechanisms, such as a ‘limit up-limit down’ process, to limit extraordinary market volatility.”

The SEC intends to promptly publish the proposed plan for a 21-day public comment period, and then determine whether to approve it shortly thereafter.