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SEC Approves Exchange Proposal to Adjust U.S. Trading Curbs
All U.S. stock trading will halt when the Standard & Poor’s 500 Index falls 7 percent. Photographer: Scott Eells/Bloomberg

The Securities and Exchange Commission approved two proposals to alter trading curbs meant to curtail volatility in the U.S. stock market.

The regulator approved a system known as limit-up/limit-down that prevents trades at prices outside a specified band, according to a statement on the SEC website yesterday. It also backed changes to broader circuit breakers instituted after the 1987 market crash that halt exchange-listed securities in U.S. markets during periods of volatility. Both programs will be implemented on Feb. 4 for a one-year pilot period.

U.S. stock exchanges and the Financial Industry Regulatory Authority, which oversees more than 4,400 brokers, introduced curbs for individual stocks after the May 2010 rout known as the flash crash to halt shares when they rise or fall at least 10 percent in five minutes. Exchanges asked for permission 13 months ago to test the limit-up/limit-down system and updated their proposal on May 24.

“Limit-up/limit-down will make incremental but material improvements to the single-stock circuit breaker plan,” Jamie Selway, head of liquidity management at New York-based Investment Technology Group Inc., said in a phone interview. “Halts won’t go off for goofy reasons as much as they have in the past and limit-up/limit-down will work a lot better in the context of a flash crash. The marketwide circuit breaker changes also provide helpful improvements to the legacy approach.”

Flash Crash

By the time the updated programs are in place, almost three years will have passed since the flash crash. Selway said the SEC took too long to approve the changes.

“The initiatives we approved are the product of a significant effort to devise a sophisticated, yet workable and effective way to protect our markets from excessive volatility,” SEC Chairman Mary Schapiro said in the statement. “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.”

Under the limit-up/limit-down system, which will replace the current practice of immediate halts when prices for individual securities become volatile, trades won’t be allowed to take place more than a specified percentage above or below the average price over the preceding five-minute period. If trading isn’t able to occur within the price band for more than 15 seconds, a five-minute halt will ensue, the SEC said.

Price Bands

Each stock will be allowed to move a certain percentage from its five-minute average, with the amount varying based on its closing price the prior day.

The price band will be 5 percent above and below for stocks higher than $3 in the Standard & Poor’s 500 Index and Russell 1000 Index and a group of about 430 exchange-traded products, the SEC said. It will be 10 percent for other securities higher than $3. Those between 75 cents and $3 can move up to 20 percent, while those less than 75 cents can move the lesser of 75 percent or 15 cents.

The plan will be implemented in two phases. It will initially apply to S&P 500 and Russell 1000 stocks and the group of ETPs, with price bands calculated from 9:45 a.m. New York time until 3:30 p.m. The second phase, which will start six months later, will operate from the start of trading at 9:30 a.m. until the close at 4 p.m. and apply to all securities.

‘Normal’ Trading

The limit-up/limit-down plan will also give the market that lists a security the discretion to declare a trading pause when a stock has “deviated from its normal trading characteristics” and the exchange decides that a halt would curtail excessive volatility, the SEC said. This will ensure a company’s shares don’t “remain impaired” indefinitely, it said.

The commission said it expects exchanges will eliminate the volatility curbs that apply only on their own venues. The New York Stock Exchange currently has a system of so-called liquidity replenishment points to limit rapid price moves on its market. NYSE Euronext Chief Operating Officer Larry Leibowitz has credited the system with preventing stocks his company lists from trading at aberrant prices such as pennies during the flash crash.

The exchanges and Finra will create an advisory committee with representatives from a retail broker, institutional securities firm, alternative trading platform and an investor to offer their views on prospective changes to the limit-up/limit-down system. While the committee can’t vote, “it’s nice to have their input hard-coded into the process,” Selway said. The exchanges and Finra told the SEC in a Nov. 2 letter that advisers were unnecessary.

1987 Crash

The SEC also changed the marketwide circuit breakers, created in the aftermath of the October 1987 crash, because they weren’t triggered during the May 6, 2010, rout that erased $862 billion from U.S. equities in less than 20 minutes. The alterations will make the curbs “more meaningful and effective in today’s high-speed electronic securities markets,” the agency said in its approval order.

All U.S. securities trading will halt for 15 minutes when the S&P 500 falls 7 percent before 3:25 p.m. The trigger is currently a 10 percent drop in the Dow Jones Industrial Average. The proposal also shortens the length of most halts and modifies the times when the circuit breaker can be triggered. A plunge of 20 percent will cause all trading to stop for the day. The marketwide pause has been triggered only once, on Oct. 27, 1997.

Nobel Prize

An advisory committee to the SEC and Commodity Futures Trading Commission recommended changing the marketwide system. The advisers included Joseph Stiglitz, an economist who won the Nobel Prize; David Ruder, a former SEC chairman; Brooksley E. Born, who was chairman of the CFTC; and John J. Brennan, chairman emeritus and senior adviser at Vanguard Group Inc.

The owner of the Chicago Mercantile Exchange is examining the SEC’s approval of the marketwide circuit breakers, Michael Shore, a spokesman for CME Group Inc., wrote in an e-mail. The company has circuit breakers for equity-index futures that are consistent with those in the stock market.

“CME Group has been a strong advocate for more appropriately calibrated marketwide circuit breaker trigger levels that are coordinated across trading venues,” Shore said. “We have commented extensively on the proposals, are currently evaluating the changes approved by the SEC and will be submitting proposed amendments to our rules in the near future.”

The lack of a linkage between the curbs for individual securities and those that halt all trading is a risk, Selway said. CME Group and the Securities Industry and Financial Markets Association urged the SEC to allow marketwide curbs to be triggered if a sufficient number of individual stocks are halted since that may affect the calculation of indexes. The SEC said market participants could submit comments about this issue while the programs are being tested.

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