On May 31, 2012, the Securities and Exchange Commission (SEC) approved two proposals submitted by the national securities exchanges and the Financial Industry Regulatory Authority (FINRA) designed to address extraordinary volatility in individual stocks as well as the broader U.S. stock market. One initiative establishes a “limit up-limit down” mechanism to prevent trades in individual exchange-listed stocks outside of a specified price band. When implemented, this new mechanism will replace the existing market-wide circuit breakers that the SEC approved on a pilot basis after the market events of May 6, 2010. The second initiative updates existing market-wide circuit breakers that when triggered, halt trading in all exchange-listed securities throughout the U.S. markets. The proposals will be operative on a one-year pilot basis, beginning February 4, 2013.
“Limit Up-Limit Down” Plan for Individual Securities
The “limit up-limit down” mechanism, established jointly by the exchanges and FINRA, prevents trades in individual listed equity securities outside of a specified price band, set as a percentage level above and below the average price of the security over the immediately preceding five-minute period. In essence, the security would enter a “limit state” if its price moves a certain percentage. For more liquid securities — those in the S&P 500 Index, Russell 1000 Index, and certain exchange-traded products — the level will be 5%, and for other listed securities the level will be 10%. The percentages will be doubled during the opening and closing periods and broader price bands will apply to securities priced $3 per share or less.
To accommodate more fundamental price moves, a five-minute trading pause will be triggered if trading does not occur within the price band for more than 15 seconds.
Under the new plan all trading centers, including exchanges, automated trading venues, and broker-dealers executing trades internally, must establish policies and procedures to prevent trades from occurring outside the applicable price bands, comply with trading pauses, and otherwise comply with the procedures set forth in the plan.
Market-Wide Circuit Breakers
The second initiative updates existing market-wide circuit breakers that when triggered, halt trading in all exchange-listed securities throughout the U.S. markets. The updated market-wide circuit breakers lower the percentage-decline threshold for triggering a market-wide trading halt and shorten the amount of time that trading is halted. Notably, the market-wide circuit breakers were not triggered during the severe market disruption of May 6, 2010, and since their adoption in 1988, were triggered only once.
The revised market-wide circuit breaker rules update the existing rules by:
- Reducing the market decline percentage thresholds needed to trigger a circuit breaker to 7%, 13% and 20% from the prior day’s closing price, rather than declines of 10%, 20% or 30%.
- Shortening the duration of trading halts that do not close the market for the day to 15 minutes, from 30, 60 or 120 minutes.
- Simplifying the structure of the circuit breakers so that there are only two relevant trigger time periods - those that occur before 3:25 p.m. and those that occur on or after 3:25 p.m. The two periods replace the current six-period structure.
- Using the broader S&P 500 Index, rather than the Dow Jones Industrial Average, as the pricing reference to measure a market decline.
- Requiring the trigger thresholds to be recalculated daily rather than quarterly.
“Workable and Effective”
SEC Chairman Mary Schapiro described the initiatives as “the product of a significant effort to devise a sophisticated, yet workable and effective way to protect our markets from excessive volatility.” Chairman Schapiro added that, “In today’s complex electronic markets, we need an automated and appropriately calibrated way to pause or limit trading if prices move too far too fast. The Commission, along with the exchanges and FINRA, will be closely monitoring the operation of the new limit up-limit down and market-wide circuit breaker processes during the pilot period to make sure any rules approved on a permanent basis are as effective as they can be."
One-Year Pilot Period
The SEC approved both proposals for a one-year pilot period, during which the exchanges, FINRA, and the SEC will assess their operation and consider whether any modifications are appropriate.
While other initiatives have been undertaken by the SEC in the wake of May 6, 2010 to address volatility, including, among other things, a rule requiring broker-dealers to have risk controls in place before providing their customers with access to markets, and new exchange and FINRA rules to strengthen the minimum quoting standards for market makers and effectively prohibit “stub quotes” in the U.S. equity markets, the SEC is also considering what additional measures may be needed, including establishing a consolidated audit trail system to better track orders and trades in securities across the national market system.
For your convenience, to access the National Market System Plan Approval Order, click here and to access the Market-Wide Circuit Breaker Approval Order, click here.
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