On the afternoon of Thursday, May 6, 2010, in an event that some have been calling the “flash crash,” stock prices suffered an unprecedented period of volatility when the Dow Jones Industrial Average fell nearly 1,000 points in a short period of time, only to partially rebound shortly thereafter. In the days that followed, any number of theories were floated to explain the possible cause or causes of the events of that day, including the Greek economic crisis and the world economic situation generally, aberrant trading in certain exchange traded funds (“ETFs”) and/or stock index futures, a disparity in exchange rules and procedures, the absence of liquidity providers as the market was falling, one or more significant trader errors, and even hacker or terrorist activity. At this point, no one is really certain whether it was a single event or, as is more likely, a confluence of some of the foregoing factors, and it will take some time (as well as signicant data analysis) to reach any final conclusions. However, the Securities and Exchange Commission (the “SEC”), the national securities exchanges, and the Financial Industry Regulatory Authority (“FINRA”), as well as the Commodity Futures Trading Commission (the “CFTC”), are already taking action to uncover and address the possible causes of the flash crash. And given the significant downward market correction on Thursday, May 20, the push to quickly develop additional corrective regulation is likely to gain momentum.
I. Circuit Breakers
The most immediate substantive action taken to reduce the possibility of another flash crash, no matter what the cause, was announced in an SEC press release on the afternoon of Tuesday, May 18, which stated that the national securities exchanges and FINRA would each be filing proposals to adopt uniform “circuit breaker” rules designed to halt trading in certain stocks that experience a rapid price movement.1 According to SEC Chairman Mary Schapiro, “[w]e continue to believe that the market disruption of May 6 was exacerbated by disparate trading rules and conventions across the exchanges,” thus highlighting the need for the markets to reach consensus on a set of uniform circuit breakers.
The exchanges have each published their circuit breaker rule proposals. Initially, they will apply only to component stocks of the S&P 500 (referred to in some of the rules, and generally herein, as “circuit breaker securities”).2 Generally, trading in circuit breaker securities will pause across U.S. equity markets for five minutes if the stock experiences a 10 percent change in its price over the preceding five minutes. This will enable the markets to attract new trading interest in the stock, establish a reasonable market price for it, and resume trading in a fair and orderly manner. The new rules will be made effective on a pilot basis through December 10, 2010, in order to allow the markets to adjust the parameters or operation of the circuit breakers based on actual market experience, and to expand the universe of circuit breaker securities as necessary.
The circuit breaker rules can be divided into two categories, the rules of those exchanges that are primary listing markets, and the rules of FINRA and those exchanges that are not primary listing markets.
Primary Listing Markets
The proposed rules of each primary listing market3 provide for a “trading pause” to be imposed for any circuit breaker security for which that exchange is the primary listing market, if the security’s price moves 10 percent or more from the price of a sale of the stock reported to the consolidated tape within the preceding five minutes. To accommodate the opening and closing of the markets, the proposed rules will operate from 9:45 a.m. to 3:35 p.m., Eastern Time. Each primary listing market’s rules set forth procedures for re-opening trading of the stock after a trading pause, and for notifying other markets if it cannot reopen because of issues unrelated to an order imbalance. This will enable the other markets to resume trading even if the primary listing market has not re-opened.
The 10 percent price movement will be calculated continuously by comparing changes in the consolidated last reported sale prices of a security over a rolling five-minute period. Because operation of each rule begins at 9:45 a.m., in the first five minutes after that, the reference prices for comparison purposes will not be based on five minutes of trading in the security.4 Only regular way, insequence transactions will qualify as reference prices to trigger a trading pause, and each exchange can exclude a transaction price from use as a reference if it resulted from an erroneous execution.
In addition, the rules of each primary listing market provide that if another exchange is the primary listing market for a security, and the security trades on an unlisted trading privilege basis on the non-listing exchange, the non-listing exchange will pause trading in that security until the primary listing market resumes trading or provides notice that trading may resume on other exchanges. If such notice is not provided, or the primary listing market does not reopen trading in the security within 10 minutes of the original notice of the trading pause, the non-listing exchange may resume trading the security.
Exchanges that are not primary listing markets will pause trading in a circuit breaker stock whenever the stock’s primary listing market imposes a trading pause. If trading does not resume on the primary listing market and 10 minutes have passed since the trading pause message was received, or the primary listing market issues a notice stating that it cannot resume trading for a reason other than a significant trading imbalance, the other exchanges may resume trading in the stock.5
FINRA’s circuit breaker rule is designed to pause over-the-counter (“OTC”) trading of circuit breaker securities if the primary listing market imposes a trading pause. FINRA will halt OTC trading of such security until trading resumes on the primary listing market. If trading does not resume on the primary listing market and 10 minutes have passed since the trading pause message was received, or the primary listing market issues a notice stating that that it cannot resume trading for a reason other than a significant trading imbalance, FINRA may permit the resumption of OTC trading if trading in the security has commenced on at least one other national securities exchange.
The SEC is seeking comment on each exchange’s rule proposal; however, there will only be a short comment period, running 10 days from the date that each proposal is published in The Federal Register. A decision on whether to approve the circuit breaker rules is expected shortly after the end of the comment period. The proposing release for each rule is currently available on the SEC’s web site:
Primary Listing Markets
II. Related Matters
In the May 18 Press Release, the SEC also noted that during the pilot period for the circuit breaker rules, the SEC staff will consider other matters relating to the flash crash, including ways to address the risks of market orders and their potential to contribute to sudden price movements, steps to deter or prohibit the use of “stub quotes,”6 and the impact of other exchange trading protocols, including trading pauses and self-help rules. The SEC staff also will continue working with FINRA and the exchanges to improve the process for breaking erroneous trades, and to consider adjusting the existing market-wide circuit breakers that were not triggered on May 6.
III. CFTC/SEC Staff Report on the Events of May 6, 2010
On May 18, 2010, the staffs of the SEC and CFTC (the “Staffs”) issued their 151-page initial report to the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues (the “Committee”).7 The Report sets out the Staffs’ preliminary findings regarding the flash crash, and is intended to brief the Committee regarding those events and provide it with context regarding the current structure and regulatory framework of the equity and futures markets. The Report emphasizes that the review is in its preliminary stages, and that reconstructing even a few hours of trading during an extremely active trading day requires creating, formatting, and collecting enormous amounts of data, which then must be carefully validated and analyzed. The Staffs expect to supplement the Report with additional findings and analyses.
The Report analyzes events surrounding the flash crash, including news regarding the European debt crisis and the generally downward trend of the market, which suddenly accelerated on the afternoon of May 6, only to reverse itself shortly thereafter. According to the Report, “[t]his extreme volatility in the markets suggests the occurrence of a temporary breakdown in the supply of liquidity across the markets.” The Report notes the unprecedented speed and scope of the decline and rebound of prices, which undermined confidence in the markets. The Report states that, despite earlier reports, there was no evidence that the flash crash was triggered by trader errors, computer hacking, or terrorist activity (although the Staffs did not completely rule out those possibilities). With respect to the futures markets, the Report’s preliminary findings include a conclusion that a liquidity drain is likely to have played a role in the sudden and dramatic price movements in stock index futures. For example, although trading volume in “E-mini S&P 500” futures was very high, there were far more sell orders than buy orders that afternoon, and certain active traders partially withdrew from the market. This caused CME’s Globex “stop logic” functionality8 to initiate a pause in trading the E-mini S&P 500 futures.
According to the Report, the Staffs continue to focus on:
- Possible links between the rapid decline in prices of stock index products such as index ETFs and E-mini S&P 500 futures, simultaneous and subsequent waves of selling in individual securities, and the extent to which activity in one market impacted others;
- General mismatches in liquidity, possibly aggravated by the withdrawal of electronic market makers, and the impact of automated stop loss market orders, which can trigger a chain reaction of significant automated selling in a fast-falling market;
- The extent to which the lack of liquidity may have been exacerbated by the disparate trading conventions of various exchanges, making trading slower in some than in others;
- The use of stub quotes; and
- The disparate impact of the market decline on ETFs, which suffered a disproportionate number of broken trades relative to other securities. The Report also outlines certain key areas for additional investigation, including:
- Links between trading in equity index products, including stock index futures, and the equity markets;
- Differences in trading practices among multiple markets trading the same stocks simultaneously, which may have led to fragmented trading in some securities.
- Disparate exchange practices regarding the use of the Regulation NMS “self-help” remedy, which resulted in two exchanges declaring self-help against NYSE Arca in the middle of the market free-fall, and may have led to a net loss of liquidity as those two exchanges stopped routing orders to NYSE Arca;9 and
- The use of short sales and stub quotes (since preliminary analysis indicates that short sales may have accounted for nearly 70 percent of executions against stub quotes between 2:45 p.m. and 2:50 p.m. on May 6, and approximately 90 percent of executions against stub quotes between 2:50 p.m. and 2:55 p.m.).10
With respect to the securities markets, the SEC staff intends to continue investigating the nature of the overall liquidity dislocation on May 6, 2010, and its impact on individual securities. The Report mentions the impending exchange and FINRA circuit breaker rules, and states that they should provide an opportunity for all available sources of liquidity “to be mobilized to meet sudden surges in demand for liquidity.” The Report also states that procedures for breaking trades at off-market prices should be improved to provide greater consistency, transparency, and predictability, and notes that the SEC staff will continue to review other policy options.
With respect to the futures markets, the CFTC staff will continue to analyze the events of May 6, focusing on the activity of the largest traders in stock index futures. The CFTC staff will also continue to analyze the provision of liquidity in the futures markets, focusing particularly on electronic trading, including high frequency and algorithmic trading; automatic execution innovations; market access issues; and co-location.11 The CFTC staff also may propose rules relating to co-location services to ensure that all qualified and eligible market participants have equal access to them. In addition, the CFTC will consider rules to enhance its surveillance capabilities, including automation of the “statement of reporting traders” in the large trader reporting system, and obtaining account ownership and control information in exchange trade registers.
The Staffs also intend to pursue a joint study of linkages between the equities, options, and futures markets, and to re-examine existing cross-market circuit breaker provisions to ensure that they continue to be effective.