The Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues (the “Committee”) recently issued its report and recommendations relating to the market events of May 6, 2010, dubbed the “Flash Crash”. Click here to see the full text of the Committee’s report.
The Flash Crash
On May 6th 2010, stocks suddenly plunged in a massive sell-off, causing the Dow Jones Industrial Average (“DJIA”) to fall nearly 1,000 points before rebounding just as quickly. This was the biggest one-day point drop in the history of the DJIA and the third highest volume day ever. The CFTC and the SEC set out to piece together what happened and ways to ensure that it never happens again.
The Committee’s Report & Recommendation
The Committee’s report makes recommendations directed to U.S. securities and futures regulators. While these recommendations may or may not be turned into rules, they provide insight into what any final rules ultimately adopted might look like. The CFTC and SEC are taking public comments on these recommendations. If you’d like to make a comment, click here.
The Committee’s recommendations affirm some of the measures put in place soon after the Flash Crash, suggest greater investigation and research into others, and provide new far-reaching suggestions to regulate modern markets which are dominated by high-speed electronic trades and populated by algorithmic trading strategies.
Current SEC & FINRA Initiatives
Several of the Committee’s recommendations support current initiatives already underway at the SEC and the Financial Industry Regulatory Authority (“FINRA”).
In particular, the Committee concurred with the steps the SEC has taken to create single stock pauses/circuit breakers, enact rules that provide greater certainty as to which trades will be stopped when there are multi stock aberrant price movements, and implement minimum quoting requirements by primary and supplemental market makers.
Under the pilot program implemented by the SEC & FINRA in June 2010, a single stock circuit breaker is triggered if the price of a security changes by 10 percent or more within a rolling five-minute period between 9:45 a.m. and 3:35 p.m. This pause in trading allows the primary listing market to consider the trading that has occurred, correct any erroneous orders and decide whether trading should resume.
Work to Be Done
Other recommendations are simply suggestions by the Committee to continue research and investigations into corrective measures currently being considered by regulators. For example, the Committee recommended that the:
- SEC work with the exchanges and FINRA to implement a “limit up/limit down” process to supplement the existing pause rules;
- CFTC and the relevant derivative exchanges evaluate whether a second tier of pre-trade risk safeguards with longer timeframes should be instituted when the “five second limit” does not attract contra-side liquidity;
- CFTC and SEC clarify whether securities options exchanges and single stock futures exchanges should continue to trade during any equity limit up/down periods; and
- CFTC and SEC evaluate the present system-wide circuit breakers and consider reducing, at least, the initial trading halt to a period of time as short as ten minutes, allowing the halt to be triggered as late as 3:30 pm, and using the S&P 500 Index as the triggering mechanism.
The Committee also made several recommendations which seemingly address the potential causes of the Flash Crash, including the:
- imposition of strict supervisory requirements on designated contract markets and futures commission merchants that employ or sponsor firms implementing algorithmic order routing strategies;
- consideration of the costs and benefits of directly restricting “disruptive trading activities” with respect to extremely large orders or strategies by the Commissions;
- evaluation by the SEC of whether incentives or regulations can be developed to encourage persons who engage in market making strategies to regularly provide buy and sell quotations that are “reasonably related to the market”; and
- development of effective testing of sponsoring broker-dealer risk management controls and supervisory procedures by the SEC & FINRA.
More Aggressive Ideas
The Committee made several recommendations that may run into greater resistance given their relative novelty. Specifically, the Committee recommended that the:
- SEC evaluate the potential benefits that might be gained by changes in maker/taker pricing practices, including building in incentives for the exchanges to provide for “peak load” pricing models;
- SEC analyze the impact of a broker-dealer maintaining privileged execution access as a result of internalizing its customer’s orders or through preferencing arrangements and consider (i) adopting the Committee’s proposed rule requiring the execution of internalized or preferenced orders at a price materially superior (e.g., 50 mils for most securities) to the quoted best bid or offer, and/or (ii) subjecting firms that internalize customer order flow or executing preferenced order flow to execute a material portion during volatile market periods;
- SEC study the costs and benefits of adopting an alternative routing requirement implemented through a “trade at” routing regime, “top of book” protection protocol and greater protection to limit orders placed off the current quote or increased disclosure of relative liquidity in each book; and
- CFTC and SEC consider requiring a uniform fee across all exchange markets that is assessed based on the average of order cancellations to actual transactions effected by a market participant.
The CFTC and SEC have expressed their intent to give the Committee’s recommendations consideration in their rule-writing processes. Consequently, the Report provides tremendous insight into the possible corrective measures that many regulators may enact in the near future.