On 4 April, the US Securities and Exchange Commission (SEC) announced, after several extensions, that it would finally decide whether to approve a new volatility-mitigation plan for the US equities market by 31 May. The new mechanism would replace the current single-stock circuit breakers for securities in the S&P 500 and Russell 1000 indices and certain exchange-traded funds (ETFs) sets to expire on August 11, or sooner if the new plan is implemented prior to the deadline.
The plan, developed by a consortium of the leading US equities and equity options exchanges – including NYSE Euronext, Nasdaq OMX, BATS Global Markets, Direct Edge and Chicago Stock Exchange – in league with the Financial Industry Regulatory Authority (FINRA), seeks to replace the single-stock circuit breaker pilot that has been in position since June 2011 to better address extraordinary market volatility, such as experienced on 6 May, 2010.
Under the proposed approach, the market would implement a market-wide limit up-limit down requirements that would prevent trades from occurring outside dynamic price bands above (limit up) and below (limit down) a reference price determined based on a stock’s price over its past five minutes of trading and using prices provided by the securities information processor (SIP) data feed.
Unintended consequences
Of the buy- and sell-side firm that have responded to the SEC’s consultation on the proposal, most agree with the plan’s basic concept. Yet buy-side representatives are far more eager to roll out the new pilot, while the brokers would like to address a number of incremental cost and complexity issues as well as other unintended consequences prior to launch.
“[W]e think it is important to implement the proposal as quickly as possible,” wrote George Sauter, managing director and chief investment officer of The Vanguard Group in his June 22, 2011 comment letter to the SEC. “The current single-stock circuit breaker pilot has been successful, yet mini-flash crashes continue to occur among tier 2 stocks. We believe this pilot has proven the merits of the concept and the proposal should be implemented across the board without delay.”
Karrie McMillan, general counsel for the Investment Company Institute (ICI), also suggested in a separate letter dated the same day that the scheme include as many stocks as possible, including ETFs, to gather as much empirical data as possible.
Too much data might pose a serious problem according to sell-side representatives. By adding two new data points, i.e. the limit up and limit down prices, to the eleven existing fields in an equities market data message, the new mechanism would increase market data message size approximately 20%, which would have immediate knock-on effects for market participants.
“There would be an incremental cost to adding the limit up-limit down data to the market data feed, which is read by various systems that relay the information to the trading desk for trading decisions and compliance systems to ensure compliance,” says Michael Corrao, managing director, head equity compliance officer at Knight Capital Group, a broker-dealer.
In his 23 June 2011 letter to the SEC, Jose Marques, global head of electronic equities at Deutsche Bank Securities, worried how the pilot would interact with deployed volatility-mitigation platforms like NYSE Euronext’s Liquidity Replenishment Points, Nasdaq OMX’s Volatility Guards and Regulation SHO’s alternative up-tick rule. “We are concerned about circuit breaker overload in that the proliferation of market constraining mechanisms can be very confusing to the market participants and difficult to implement,” he wrote. The SEC shared Marques’ concerns and in January 2012 extended its consultation in the interests of ensuring that updated market-wide circuit breakers would interact effectively with the new limit up, limit down plan.
Investor education
The sell-side equities desks will not be the only ones that will need to be educated on the limit up-limit down plan. Knight’s Corrao sees professional traders adapting to it much easier than retail investors, since the futures markets have been using limit up-limit down mechanism for years.
“It is easy for a retail investor to understand when a security is halted,” he explains. “Under the proposed rule, brokers will not tell the investors that the stock is halted. Instead they will have to explain the somewhat complicated limit up-limit down rule and why the investor’s order cannot be executed. Then the retail investor will ask what that means.”
Another investor concern identified by Stuart Kaswell, executive vice president and general counsel at the Managed Fund Association, in his 21 June, 2011 letter to the SEC is the relationship between ETFs and their components under the new scheme. “If one or more components of an index have a trading pause while others remain open, spreads of the index products are likely to increase to the uncertainty of the price of the underlying instrument(s),” he wrote. “Further, traders providing index arbitrage between the derivative/ETF and the underlying basket may decline to trade entirely under such circumstances if they do not have a way to hedge their risk.”
For sell-side participants, they also want to be assured that the plan will implement a level playing field for all traders. Themis Trading, a brokerage, queried whether using SIP-supplied data to calculate the dynamic limit bands would provide co-located firms an advantage since they receive direct lower latency market data that would allow them to see quotes approaching the bands faster than those relying on SIP data.
Pilot bridges gap
In the meantime, the single-stock circuit breaker pilot is fulfilling its purpose as demonstrated when a programming bug in BATS Exchange’s systems led to a five-minute halt in trading of Apple and selected other during the exchange’s attempted IPO on March 23, say some on the sell side.
“It is possible that the single-stock circuit breaker could continue to operate in lieu of the very complex limit up-limit down,” says Corrao.
Although both mechanisms address the same issue, Corrao believes the limit up-limit down mechanism, if deployed, could improve market liquidity by not using a “one size fits all” approach to stocks regardless of their levels of liquidity.
“One benefit with the limit up-limit down rule it that it would allow stocks to continuously to trade while preventing the trading at dislocated prices,” he says. “Allowing continuous trading would permit liquidity to flow into the security as a stock approaches its limit up or limit down price.”