Securities and Exchange Commission (SEC) chairman Mary Schapiro told the US Congress yesterday that the sharp drop in US stock prices on 6 May demonstrated the “urgency and importance” of its efforts to reform US equities markets.
Appearing before a subcommittee of the US House of Representatives’ committee on financial services, Schapiro said the sudden 9.16% slump in the Dow Jones Industrial Average was “unacceptable”, but provided “greater urgency for the Commission to vigorously pursue a number of meaningful initiatives to promote investor confidence in the integrity and fairness of the securities markets, including a number of proposals already underway”.
According to Schapiro, the SEC’s Market Structure Concept Release, issued in January, already raised a number of concerns about the current functioning of US equities markets highlighted by the 6 May slump, such as the markets’ ability to absorb short-term volatility, the availability of liquidity from proprietary high-frequency market makers and the monitoring and management of systemic risk.
In addition to its concept release, the SEC has also recently issued proposals to ban flash orders, increase the transparency of dark pools and tighten current rules on market access. “The events of 6 May demonstrate the urgency and importance of these efforts and provide a valuable concrete example of how the market structure performed under particularly stressful conditions. As such, they highlight particular regulatory steps that warrant close attention in the near future,” said Schapiro.
Although the trigger for the sudden drop in stock prices on 6 May remains unclear, the decision by the New York Stock Exchange (NYSE), which operates a hybrid trading model, to slow down market activity – without similar actions being initiated by other fully electronic trading venues – is widely considered to have accelerated the selling activity that briefly drove the price of some blue-chip stocks to sub-penny levels.
In the event of extreme market volatility, NYSE’s established practice is to revert to floor-trading-only mode to allow designated market makers or specialists to add liquidity via ‘liquidity replenishment points’. But under RegNMS, other exchanges can declare ‘self-help’ if they believe another venue is experiencing systems problems. Electronic-only venues did this on 6 May when NYSE went into slow mode and effectively ignored its bids and offers, routing to other venues where liquidity very quickly dried up, resulting in plummeting prices.
Schapiro said that all options should be considered for improving market making and liquidity provision in volatile market conditions, but prioritised further investigation of ‘time out’ mechanisms to maintain orderly markets. Although market-wide circuit-breakers can suspend all trading in the event of steep drops in US equities indices, no universal mechanism is currently in place to respond to unusual market activity in individual stocks. Proctor & Gamble, for example, opened the day at $61.91, but fell to $39.37, before rebounding to close at $60.95, In their testimony to Congress, Eric Noll, Nasdaq’s executive vice president for transaction services, and Lawrence Leibowitz, chief operating officer, NYSE Euronext, agreed with Schapiro that any stock-specific circuit breaker would have to be effective across all venues on which US stocks can be traded.
Robert Iati, partner and global head of consulting at TABB Group, foresaw no serious regulatory or technological barrier to creating a universal circuit breaker in the US equity markets. “There just needs an agreement [between trading venues] for this oversight to be corrected in short order,” he said. Iati suggested two possible models: either all trading venues agree to stop trading in the event of the exchange with the largest volume in an affected stock calling a halt to trading activity; or the SEC takes responsibility for triggering a break in trading across all markets. “To work effectively, any universal circuit-breaker would have to include dark pools and broker crossing networks,” he added.
In addition to extended use of circuit-breakers, the SEC will consider further steps to limit the future impact of similar market conditions to 6 May, including: exchange-level erroneous order filters; “collars” on the prices at which market orders or aggressively priced limit orders can be executed; limitations on the size of market orders or aggressively priced limit orders; and eliminating the practice of displaying stub quotes “that were never intended to be executed”.
The SEC’s Schapiro also told Congress that the sudden disappearance of liquidity on 6 May was also a concern and suggested that electronic market makers, which use high-frequency trading techniques based on historical trading patterns, may have automatically exited the market when market activity did not correlate with their models. “Algorithms may be very effective in adding liquidity in normal trading conditions,” she said, “but may be inherently ineffective in adding liquidity when dealing with highly unusual events such as occurred on 6 May”.
Bernie McSherry, senior vice-president for strategic initiatives at US broker Cuttone & Company, agreed with Schapiro’s assertion that “people have the capacity, flexibility, and creativity” to respond to extreme market conditions. Cuttone has a large floor-trading presence at NYSE, but also trades electronically across a wide range of US trading venues. McSherry argues that NYSE’s liquidity replenishment points offer an approach that could be followed in other venues. “You only need specialists four or five times in a decade and last Thursday was one of those days. People need them in the bad times but don’t like to see them make money in the good times,” he said.
McSherry added that the absence of liquidity on alternative trading venues once the NYSE slowed down trading suggested a greater reliance on the primary market than had recently been supposed.