Proposed by the national securities exchanges and the Financial Industry Regulatory Authority in the wake of the chaotic trading of that day, the rules were accepted as policy yesterday (Thursday) by the US Securities and Exchange Commission.

They will oblige all exchanges and Finra to halt trading in any stock that rises or falls more than 10% in a five minute period. The halt will last for five minutes and must be applied by all trading venues at once. Listed options on the suspended stock would also be frozen.

The circuit breakers will come into effect 15 minutes after the stockmarkets’ 9.30am opening in New York, and will be turned off for the last 25 minutes of the day, up to 4pm.

At first only stocks in the S&P 500 Index will be covered, but after the initial pilot period until December 10, the SEC is keen to extend the circuit breakers to “thousands” more listed stocks and exchange-traded funds. The rules may also be tweaked after the pilot.

Such automatic suspensions are used at many exchanges – for example, the Russian Trading System Stock Exchange often had to close completely for a morning or afternoon session during the savage bear market of autumn 2008.

And on May 20 this year, Eurex suspended trading in front month Euro Stoxx 50 Index Futures, one of its most liquid contracts, due to an extreme fall. The exchange’s volatility interruption safeguard is triggered if an instrument moves outside a predefined range, which the exchange does not disclose, within a set period. Eurex used the safeguard several times in May, including on May 6.

Risk of making things worse

Critics say circuit breakers could exacerbate volatility by making market participants even more eager to get out of losing positions as soon as the suspension ends.

The SEC and Commodity Futures Trading Commission have not yet finished their investigation into the May 6 flash crash, but it is thought that a sharp fall in price of the E-Mini S&P 500 Index Futures at CME Group might have triggered preset sell orders in many trading algorithms, causing a sudden run on US stocks, indices and exchange-traded funds.

Most of these soon recovered to what the SEC called “prices consistent with their pre-decline levels”, but many trades were made at the depressed prices, some of them 60% lower than a few minutes earlier.

The events fed a general anxiety, shared by the public, some politicians and regulators, and many market participants, that the rapid growth of high frequency algorithmic trading may have made markets less stable.

At one of the panels on high frequency trading at the FIA/FOA International Derivatives Expo in London this week, most of the panellists admitted they were worried by the potential consequences of HFT, even though all the speakers were involved commercially with HFT in some way.

At another panel, Steve Grob, director of strategy at software vendor Fidessa, said it was “quite simple” what happened on May 6: “A bunch of market makers on CME stopped making markets in the S&P. That meant cash players couldn’t hedge their positions, so they pulled out of the cash market.” Grob meant to argue that HFT had not played any sinister part in the events.

Algos in the dock

Nevertheless, it is clear computer-driven trading is the target of the circuit breakers. The SEC is not trying to stop stocks crashing (or zooming up), just to interrupt glitch-like trading in which a spiral of triggered orders can push a stock too far.

“The May 6 market disruption illustrated a sudden, but temporary, breakdown in the market’s price-setting function when a number of stocks and ETFs were executed at clearly irrational prices,” said SEC chairman Mary Schapiro in the statement announcing the rules. “By establishing a set of circuit breakers that uniformly pauses trading in a given security across all venues, these new rules will ensure that all markets pause simultaneously and provide time for buyers and sellers to trade at rational prices.”

The pause is intended, the SEC said, “to give the markets the opportunity to attract new trading interest in an affected stock, establish a reasonable market price, and resume trading in a fair and orderly fashion”.

Next steps

Schapiro has also asked SEC staff to:

- Consider ways to address the risks of market orders and their potential to contribute to sudden price moves

- Consider steps to deter or prohibit market makers’ use of ‘stub’ quotes, which are not intended to indicate actual trading interest.

- Study the impact of other trading protocols at the exchanges, including the use of trading pauses and self-help rules

- Continue to work with the exchanges and Finra to improve the process for breaking erroneous trades, by assuring speed and consistency across markets.

The SEC staff is also working with the markets to consider recalibrating marketwide circuit breakers already on the books which apply to all equity trading venues and the futures markets. None of these safeguards were triggered on May 6.

The regulator received 26 comments on its proposals between May 24 and June 7. Most were broadly supportive, though often suggesting variations on the proposals. A few suggested alternative safeguards be used, including using a futures-style ‘limit down’ instead of a circuit breaker, or allowing trading at prices that reverse the triggering price change.

Jon Hay +44 207 779 8372 jhay@fow.com