Thursday, May 20, 2010

SEC Circuit Breaker Rule Proposal

The dramatic drop in the stock market that occurred on May 6 causing the Dow Jones Average to plummet 1,000 points, 10% of its total value, in a half hour has prompted the Securities and Exchange Commission to propose a rule that would pause trading of individual stocks if the trading price falls 10 percent or more in a five-minute period. A Wall Street Journal article 'Flash Crash' Plan: a Circuit Breaker for Every Stock reports the SEC proposed rule change announced this week. The SEC is working with the Financial Industry Regulatory Authority (FINRA) on this issue.

SEC Chairman Mary Schapiro said she believed that disparate trading rules and conventions across the exchanges exacerbated the "flash crash". The proposed rule comes as the SEC and the Commodity Futures Trading Commission (CFTC) released Preliminary Findings Regarding the Market Events of May 6, 2010. On page 75, the staff report states “the SEC is taking a number of steps to identify the cause or causes of the May 6 market disruption as well as factors that may have exacerbated that event, and to develop regulatory initiatives to help prevent a recurrence.”

While the cause of the "flash crash" remains unclear, the report focused on orders placed by high-frequency traders, or HFTs, firms that barely existed a few years ago but now account for two-thirds of all US stock trading. It makes these observations about high frequency traders which it defines as "professional traders that use computer systems to engage in strategies that generate a large number of trades on a daily basis.":
Both the CFTC and the SEC have had extensive conversations with a wide variety of market participants (investors, hedge funds, exchange traded funds, dealers, high frequency traders, etc.) to better understand their trading activities throughout May 6, and to gather anecdotal evidence from which common themes and/or trends can be identified to inform further areas of investigation.

The SEC needs to develop the tools necessary to readily identify large traders and be able to evaluate their trading activity is heightened by the fact that large traders, including certain high-frequency traders, are playing an increasingly prominent role in the securities markets.

See the NY Times DealBook article Speedy New Traders Make Waves Far From Wall Street for more on the growing impact of high-frequency traders.

In a press release issued by the SEC this week, Schapiro said "I believe it is important that all the exchanges quickly reached consensus on a set of uniform circuit breakers that would be triggered when needed. Today's filings reflect that consensus. I am pleased by the constructive cooperation of the exchanges and FINRA, as evidenced by their rapid response." The proposed rule is laid out in the SEC Release No.34-62131.

A CNN.Money report Schapiro: Robo-trading eyed in 'flash crash' says that Schapiro told a Senate panel that computerized trading could be responsible for the historic market plunge on May 6 and that the 1,000-point stock plunge was "possibly exacerbated by the withdrawal of liquidity by electronic market makers and the use of market orders, including automated stop-loss market orders."
This video featuring Fortune's Managing Editor Andy Server explains the more proactive regulatory stance that the SEC is now taking:


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