The SEC's recently proposed changes to the single-stock circuit breakers it enacted in 2010 have stirred up the debate over their pros and cons. Instituted in reaction to the 2010 Flash Crash, when the Dow Jones Industrial Average plunged about 1,000 points, the circuit breakers currently halt trading in a single stock when circumstances indicate the possibility of another crash. But some market participants have questioned whether circuit breakers are the best solution.
Two years later, the debate continues, and the SEC has proposed adding a "limit up, limit down" provision to the circuit breakers. "Circuit breakers are triggered frequently, and in most cases they are false positives," notes John Comerford, global head of trading research at Instinet. When a circuit breaker is triggered, the effect on the buy and sell sides is minimal, he says.
But, "If you are managing your risk in a short time horizon, it does create risk," Comerford adds. If a trader does not know when a trade might be broken and he hedges that position, Comerford explains, the trader will take on unintended exposures. Still, "Most traditional traders don't care if they can't trade in a stock for five minutes, although it is an annoyance," he notes.
Triggering of circuit breakers exacerbates other market structure issues, according to Comerford; the "limit up, limit down" proposal, he says, could solve the issue that the circuit breakers were designed to fix. The provision, which was on the SEC's agenda for the end of May, would prevent trades in listed equity securities from occurring outside of a specified price band.
Mike Corrao, managing director at Knight Capital Americas, points out that the circuit breaker rule has to be continually extended; the "limit up, limit down" provision could be a permanent replacement. "The 'limit up, limit down' provision is quite complicated and if it is approved, the industry would likely need six to eight months for implementation," he says.
"The single-stock circuit breaker has served the industry well," Corrao adds. Trading mistakes are made, and circuit breakers offer a helpful stopgap when an erroneous trade has been entered, he says. "The fact that the circuit breakers are a backstop is a good thing, but not something firms should be relying on as a method for meeting requirements under the Market Access Rule," he says.
According to reports, the circuit breakers have been deployed 110 times in the past year. Corrao says the scenario in which this happens the most is when an order outsizes the displayed liquidity. Removing all available liquidity often pushes trading through the circuit breaker level, forcing a halt in the stock's trading.
[Flash Crash Anniversary Sees More Oversight: Since the market's loss of nearly 1,000 points two years ago, circuit breakers have been activated with greater frequency.]
Corrao adds that even if "limit up, limit down" is put into place, there are other situations in which trading halts could be helpful. For example, he says, companies should not be permitted to announce intra-day earnings without a mandatory halt in trading 10 minutes before the announcement. Retail investors would be better served, Corrao insists, if trading is halted prior to a news announcement rather than as a result of the news via the circuit breakers, he suggests.
What Is the Proposed "Limit Up, Limit Down" Mechanism?
According to SEC.gov:
The proposed "limit up, limit down" mechanism would prevent trades in listed equity securities from occurring outside of a specified price band, which would be set at percentage levels above and below the average price of the security over the immediately preceding five-minute period. For stocks currently subject to the circuit breaker pilot, the percentage would be 5 percent, and for those not subject to the pilot, the percentage would be 10 percent.
The percentage bands would be doubled during the opening and closing periods, and broader price bands would apply to stocks priced below $1. To accommodate more fundamental price moves, there would be a five-minute trading pause if trading is unable to occur within the price band for more than 15 seconds.