US regulator the Securities and Exchange Commission (SEC) has announced that US exchanges and Financial Industry Regulatory Authority (FINRA) have proposed new rules to clarify the process for breaking erroneous trades.
The rules are intended to clarify when and at what prices trades would be cancelled and will complement the stock-specific circuit breakers installed by the SEC last week. The circuit breakers pause trading in individual S&P 500 stocks across all US equity markets for five minutes should its price deviate by 10% in the preceding five-minute period.
Together, the exchanges and FINRA, an independent US securities regulator, have agreed a series of thresholds for breaking trades when they diverge significantly from the last reasonable market price.
For stocks priced $25 or less, trades will be broken if the last price is at least 10% away from the circuit breaker trigger price. Stocks priced between $25 and $50 will be considered erroneous if they deviate by 5% from the circuit breaker trigger price and stocks over $50 will be broken if they move 3% away from the circuit breaker trigger price.
The circuit breakers and the proposal for breaking trades follow the ‘flash crash’ on 6 May, when US stock market values suffered a brief but severe decline. In afternoon trading, the Dow Jones Industrial Average lost almost $1 trillion in market value and some stocks traded at sub-penny levels. A definitive cause of the crash has not been identified. On the day of the slump, US exchanges initiated agreed that trades executed at 60% away from the last reasonable sale price would be broken. The SEC said the process “was not transparent to market participants”.
“Establishing clear and transparent standards for breaking trades helps provide certainty in advance as to which trades will be broken, and allows market participants to better manage their risks,” said SEC chairman Mary Schapiro.
In an interview for the Q2 2010 issue of The TRADE, Len Amoruso, senior managing director at US broker and market maker Knight Capital asserted that the process for cancelling trades required revision.
“It would be helpful if exchanges could act more quickly to cancel erroneous trades,” said Amoruso. However, he also cautioned that “this needs to be juxtaposed against whether it makes sense to adopt a purely formulaic approach for breaking trades, which will give traders more certainty as to when a trade may be cancelled but means there is a potential that trades that are not erroneous are broken”.
The rules for breaking trades will run on a pilot basis until 10 December and the SEC plans to publish the ruling in the Federal Register for a 21-day public comment period.
In light of the 6 May turmoil, the SEC is also working with futures and options regulator the Commodity Futures Trading Commission with the goal of calibrating market-wide circuit breaks across equity and futures markets.