Facebook Inc. (FB)’s initial public offering will be the biggest test of a rule introduced in 2011 to protect investors and curb volatility on the first day a company trades.
The Financial Industry Regulatory Authority reminded more than 4,400 member firms on May 15 that they shouldn’t accept buy requests known as market orders until trading begins. Such transactions are authorizations to purchase at the best available price, as opposed to limit orders that require investors to specify a minimum or maximum.
Facebook sold shares in a deal valuing the firm at $104.2 billion, the most ever for an IPO. Finra’s notice about market orders follows malfunctions that disrupted the debuts of Bats Global Markets Inc. in March and Splunk Inc. (SPLK) in April, and comes as Facebook’s listing venue, Nasdaq Stock Market, conducts tests of its computers and customers’ systems before the IPO auction.
“Since the visibility and the size of the float is so significantly larger than Bats and Splunk, there probably won’t be an issue as size and demand will help neutralize any distribution and market-making problems,” Larry Tabb, chief executive officer of Tabb Group LLC, said in an e-mail. “While the chance of a problem is very small, if there is a problem it will have huge ramifications, not just reflecting poorly on Nasdaq but on U.S. exchanges, the U.S. capital formation process and basically the functioning of the U.S. markets.”
The Finra rule follows curbs and new trading requirements implemented by exchanges and regulators after the so-called flash crash on May 6, 2010, when the Dow Jones Industrial Average plunged 9.2 percent before recovering. In addition to introducing circuit breakers, which pause trading in stocks and exchanged-traded funds when prices move 10 percent in five minutes, market makers must quote within a certain price range. New rules were also implemented to guide exchanges’ decisions about when to void errant transactions.
Facebook, which sold 421.2 million shares, may see trading volume of about 1 billion tomorrow, based on first-day activity at companies such as Google Inc., LinkedIn Corp., Zynga Inc. (ZNGA) and Yelp Inc., Tabb said. Daily trading of U.S. stocks has averaged 6.78 billion in 2012, data compiled by Bloomberg show.
The Finra ban on market orders before trading begins was instituted because shares are more volatile when there’s no “established public trading history,” the organization said.
The rule is “intended to protect investors from unintended consequences of market orders due to the potential volatility of a new issue in the secondary market,” John Markle, deputy general counsel for regulatory operations at online broker TD Ameritrade Holding Corp. (AMTD), said in an e-mail.
The prohibition went into effect in September, two months after Zillow Inc. (Z)’s debut, in which the company ranged between $32.50 and $60 on its first day. Underwriters for the Seattle-based provider of real-estate data sold stock for $20 on July 19. The next day, it opened at $60, dropped to $50 within six seconds, and ended at $35.77, according to data compiled by Bloomberg.
“Given the absence of an established trading market, the potential exists for a wide variance between the public offering price of a new issue and the price at which trading on the secondary market commences,” Finra said on May 15. “As a result, investors who place market orders for an IPO may find their orders filled at prices beyond their reasonable expectations, and such transactions may further contribute to the unconstrained increase in the price of a new issue in the secondary market.”
Market orders, or instructions to buy shares at the lowest available price at that moment, are different from limit orders, which impose a ceiling set by the investor on the level at which shares can be bought and a floor for sales. While Nasdaq can accept various types of orders, brokers can’t accept market requests before trading begins.
A broker may send a proprietary market order to buy for its own account directly to an exchange before trading commences, Finra said. If it routes the same market order to another broker it must be rejected, the organization said.
A committee set up by the NYSE and NASD, the predecessor of Finra, recommended in 2003 that market orders should be prohibited on a company’s entire first day of trading. It said this would prevent purchases of an IPO’s shares at prices that reflect neither customers’ “true investment decisions nor their reasonable expectations.” The current prohibition on market orders prior to the commencement of trading won approval instead.
A problem related to the IPO auction process on Bats Global Markets for its own shares led the Lenexa, Kansas-based exchange operator to withdraw its offering on March 23. The stock opened at $15.25 and subsequently traded at less than 1 cent.
Transactions in Splunk, a software maker that helps companies analyze Web data, triggered a volatility circuit breaker on April 19 in the first second of trading after opening at $32. NYSE Arca, an exchange owned by NYSE Euronext, later canceled the trades at $17 that led to the halt and those it executed during the required five-minute pause.
NYSE Arca said today in an e-mailed notice that it won’t run an auction to match buy and sell orders in Facebook at the start of trading tomorrow. The exchange will accept orders once Nasdaq prints the first transaction.
Trades in Caesars Entertainment Corp., a casino company, also halted shares on the first day of trading on Feb. 8 after the stock rose 50 percent minutes after the IPO auction. The circuit breakers on individual securities temporarily halt trading across all 13 equity exchanges and other markets. Regulators and exchanges are working to modify the curbs to limit price moves without immediately halting trades.
Mark Turner, head of U.S. sales trading at New York-based Instinet Inc., which accounts for almost 5 percent of daily U.S. equities volume, said he’d be surprised if circuit breakers don’t halt trading in Facebook shares more than once tomorrow.
“Given the interest in the stock, I think it’s likely to be very volatile,” Turner said in a phone interview. “There are likely to be a lot of players, a lot of retail flow, institutional flow, and price discovery right around when it opens will be quite frantic.” He said he supports the application of circuit breakers to a company’s first day of trading to “calm the market” when prices move rapidly.
Peter Jankovskis, who helps manage about $2.9 billion at Oakbrook Investments in Lisle, Illinois, said that while he doesn’t think Facebook will trigger a circuit breaker, he’s glad the curbs are in place. He said he doesn’t plan to purchase Facebook shares.
“For something like an IPO that doesn’t have a long trading history and is probably subject more to animal spirits than the trading of a seasoned issue, circuit breakers are probably a good thing,” he said in a phone interview. “It would probably frustrate me, but on the other hand it’s probably better than having an order coming in several dollars higher than I would’ve expected.”
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