Colin Clark is Senior Vice President of the Strategic Analysis & Market Data group in the U.S. Cash Markets division at NYSE Euronext. He...
On the afternoon of May 6, 2010, the major U.S. equity indices fell 5%-6% in a matter of minutes and then quickly rebounded. According to the SEC, over 20,000 trades representing 5.5 million shares across 300 securities were executed at prices more than 60% away from their values just moments before. These trades were subsequently broken under clearly erroneous rules because they we executed at prices clearly unrealistic under severe market conditions.
The “Flash Crash” highlights the fragility of the U.S. markets in high volatility periods. In the new high-speed trading world, liquidity can be fleeting and limit order books can quickly empty and stock prices can fall quickly.
To help address this issue and re-aggregate liquidity in highly volatile periods, several market-wide rules have been implemented, including volatility trading pauses (e.g. stock-by-stock circuit breakers if an active security moves 10% within a rolling five-minute period), market maker quoting requirements (requires market makers to quote within a designated percentage away from the national best bid and offer) and “naked access” rules (broker/dealer pre-trade risk controls to be implemented in July 2011).
Last week, the exchanges and FINRA together proposed a new “limit up-limit down” national market system plan, which is another market-wide safeguard to address extraordinary market volatility. The proposal “would prevent trades in listed equity securities from occurring outside of a specified price band, which would be set at a percentage level above and below the average price of the security over the immediately preceding five-minute period” (e.g., 5% price band for stocks currently subject to the circuit breaker pilot, and 10% for those not subject to the pilot). Additionally, the percentage bands would be doubled during the opening and closing periods, and broader price bands would apply to stocks priced below $1.00 and for leveraged ETFs.
The proposed limit up-limit down plan is coupled with trading pauses, which halt trading for 5 minutes.If trading is unable to occur within the price band for more than 15 seconds, then the primary exchange will declare a trading pause and the Security Information Processor (SIP) will disseminate this information to the public.
Exchanges are responsible for preventing trades at prices outside the price bands and preventing the display of bids and offers outside the bands.
The SIP will calculate and distribute the price bands. When the Pro-Forma Reference Price has moved by 1% or more from the current Reference Price, then the Pro-Forma Reference Price becomes the Reference Price and new price bands are disseminated. The SIP will also flag orders as “non-executable” when the National Best Bid (NBB) is below the lower limit band or the National Best Offer is above the upper limit band.
Phase 1 applies to stocks in circuit breaker pilot, with the remaining stocks phased in within six months.
The proposed plan will have a 21-day public comment period, and then the Commission would determine whether to approve it shortly thereafter.