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Limit-Down Alternative to Stock Halts Proposed in SEC Letters

Regulators should guard against a repeat of the May 6 selloff in U.S. stocks by imposing limits on how far shares can fall instead of halting trading, investors and a former Securities and Exchange Commission economist said.

Hudson River Trading LLC, Quantlab Financial LLC, Credit Suisse Group AG and Lawrence Harris said in comments posted on the SEC’s website that circuit breakers proposed last month risk making equity plunges worse. They recommended a system used on futures markets such as the Chicago Mercantile Exchange that subject rapidly falling securities to what are known as limit-down restrictions.

Twenty-six letters have been posted to the SEC’s website addressing a plan to impose trading halts on stocks that rise or fall 10 percent over five minutes, a pilot program that may begin next week. Regulators are examining ways to slow trading after differing rules among markets spurred a plunge that erased $862 billion from equity value in less than 20 minutes on May 6. SEC spokesman John Heine declined to comment.

“Halts will attenuate volatility if liquidity or rationality arrives before markets return to operation,” wrote Harris, now a finance professor at the University of Southern California in Los Angeles. “Allowing markets to reverse as soon as they are ready to do so is optimal because such reversals restore confidence.”

The SEC said its staff is reviewing public feedback and will present proposals to the commission this week. The circuit breakers, which have been agreed to by executives from the New York Stock Exchange, Nasdaq Stock Market and other venues, will be introduced a week after they’re approved, the agency said.

Minimizing Costs

Halts “will help reduce the likelihood of this type of unusual trading activity from recurring,” SEC Chairman Mary Schapiro said on June 2.

A limit-down rule preventing executions below a certain level may “minimize the costs associated with interrupting continuous trading and denying market participants a continuous flow of market data during critical time periods,” New York-based Hudson River and Quantlab in Houston told the SEC yesterday. Executives at Chicago-based Allston Trading LLC and RGM Advisors LLC in Austin, Texas, also signed the letter. The firms are automated trading companies.

Creating price boundaries during times of volatility would prevent transactions from occurring “outside of the acceptable range, and ‘clearly erroneous’ trades would become a thing of the past,” Dan Mathisson, the New York-based head of the Advanced Execution Services unit at Credit Suisse, told the SEC in a June 3 letter. Such rules “have been effective in curtailing severe errors or market dislocations” in futures trading, he said.

Additional Pilot

“There’s a lot of interest among the trading community in a limit down,” Mathisson said in an interview. “We hope the SEC will consider doing an additional pilot experimenting with that mechanism as well.”

Limit-down rules are triggered on the CME when equity contracts such as those linked to the Standard & Poor’s 500 Index fall 10 percent or more, according to the CME Group Inc. website. They prevent trading in securities below that price threshold, although they can still change hands above it.

Complete halts such as those envisioned in the SEC rules for individual stocks could lead to the creation of a “fear index,” said Harris. The number of stocks paused “will be widely published on radio and television, and followed on real- time electronic information systems,” he said. “It will become a focal point for fearful traders.”

Accenture’s Plunge

Accenture Plc was among stocks that plunged as low as 1 cent on May 6 as orders flowed to electronic venues with few if any buyers. U.S. exchanges later agreed to break trades that were 60 percent or more away from their price at 2:40 p.m., when the selloff intensified. Transactions in 326 securities, 70 percent of them exchange-traded funds, were broken on May 6 under rules designed to curb “clearly erroneous” transactions.

The Dublin-based company filed a letter with the SEC saying a futures-style limit-down rule might be better than a halt.

“If the most extreme prices on May 6 were caused by momentary -- millisecond long -- gaps in liquidity, prohibiting trading below a certain level in every stock would prevent the aberrant trade in the first instance,” Accenture told the SEC. If the agency opts for a circuit breaker, the firm asked for stocks not included in the S&P 500 to be part of the pilot.

Credit Suisse and Issuer Advisory Group LLC, a Chevy Chase, Maryland-based firm that advises companies about where to list stock, suggested that circuit breakers in the pilot program be in place beyond 9:45 a.m. to 3:35 p.m. since 24 percent of trading occurs in the 15 minutes before 9:45 a.m., and the last 25 minutes of the day.

Trading Pauses

Nasdaq on June 2 said it would introduce one-minute trading pauses on stocks listed on its market that swing over 30 seconds. The plan would supplement the market-wide circuit breaker and follow the NYSE’s slowdown mechanisms that were triggered 100,000 times on May 6, most for no more than a few seconds, according to Lawrence Leibowitz, chief operating officer at NYSE Euronext. Those measures, called liquidity replenishment points, were implemented in 2006.

The proposed 10 percent threshold would have been triggered at least 203 times in S&P 500 stocks and more than 10,000 times in all exchange-listed stocks this year through May 21, according to Knight Capital Group Inc., which filed a letter. It warned against letting different venues adopt different rules.

“The potential exists for various venues to introduce bespoke halts that may cause operational disruptions or confusion among individual and institutional investors,” Knight said. Regulators should “move carefully in allowing too many different instances of market halts or pauses,” it said.

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