New Short Sale Rule and Other Responses to Flash Crash

Monday, February 28, 2011, the new short sale restriction (SSR) went into effect. If a security declines 10% from the previous close, the SSR is triggered and traders can sell short only at a price one tick above the national best bid (NBB) for the rest of the day and next day. Exchanges have procedures in place to prevent the execution of a short sale order in a restricted security, unless the order is marked with a Short Sale Exempt order type. The listings exchange will notify the market by sending a message to the consolidated tape that the short sale trigger was reached.

On a given day, we estimate that 70-100 securities (particularly low-priced, less active ones) across all listed markets decline 10%+ from the previous day’s close, on average, and this amount can increase to 200 or 300 securities in more volatile markets. On May 6th, 2010, over 1,000 securities would have triggered a SSR, which would have helped to reduce downside price pressure and prevented some trade busts.

Since the “Flash Crash”, other market-wide rules have been implemented to help re-aggregate liquidity in highly volatile periods and address issues with erroneous trades and stub quotes:

·         Volatility trading pauses: In June 2010, stock-by-stock circuit breakers were rolled out and halt trading for five minutes if an active security moves 10% within a rolling five-minute period. We still need to address less active securities.

·         Market maker quoting requirements: In December 2010, new rules required market makers to quote within 8% of the national best bid and offer (NBBO) in active stocks and within 30% in less active stocks.

·         “Naked access” rules: The SEC passed rules requiring broker-dealers to put in place pre-trade risk controls and supervisory procedures to help prevent erroneous orders by July 2011.

·         Other rules: Last week, the CFTC-SEC Joint Advisory Committee recommended looking at other measures in response to the Flash Crash such as:

o   Limit up/limit down rule where orders are prevented from trading outside pre-determined price bands.

o   Reconfiguring the market-wide halt including using the S&P 500 index (rather than the DJIA) and changing the percentage triggers and time frames.

o   Fairly allocating costs imposed by high order-cancellation activity.

o   Adopting a “trade-at” rule to ensure “top-of-book” price protection for displayed orders and requiring material price improvement to internalize trades off-exchange.

 If that wasn’t enough information for you, here are some other nuances of the new SSR rule: 

·         If a short sell order can’t trade because it is at or below the NBB in a restricted security, then the exchange will re-price the order to one tick above the NBB, unless it is an Intermarket Sweep Order (ISO) or Intermediate-or-Cancel (IOC).

·         The SSR can be extended to another day if a stock falls another 10% from the previous close.

·         The SSR indicator “E” will be on the consolidated tape feed and NYSE/NYSE Amex Alerts feed.

·         There are no exemptions for market makers, for open/close/trading halts, or for leveraged ETFs.

·         At the open, sell shorts must be one tick above the NBB at 9:30 across all markets. An Order Imbalance message will indicate the SSR filing price, which is the price at which sell short interest will be included in the cross.

·         For reopening auctions following a halts on NYSE and NYSE Amex, sell shorts reopen one tick above the exchange’s best bid prior to halt. Other markets use the NBB.

·         For the close on NYSE and NYSE Amex, sell shorts are based on the exchange’s best bid at closing time. Other markets use the NBB.

·         Stock options are not covered by the SSR rule.

Exchanges and regulators have been working closely together to address the systemic risk issues occurring on May 6th. There is still more work to be done, but the industry has made good progress and has clarity on the improvements that need to be made going forward.