To address extraordinary volatility in price movements of individual stocks trading on national securities exchanges, and the broader U.S. stock market in general, the U.S. Securities and Exchange Commission (SEC), on June 1, 2012, adopted measures to automatically pause or limit trading if prices move too far too fast. For individual stocks, a ―limit up-limit down‖ mechanism prevents trades in individual exchange listed stocks from occurring outside of a specified price band. For the market as a whole, the new measures update existing marketwide ―circuit breakers‖ that, when triggered, halt trading in all exchange-listed securities in U.S. markets. The new measures, adopted for a one-year pilot period, effective February 4, 2013, were proposed by the national securities exchanges and the Financial Industry Regulatory Authority (FINRA) to address severe market disruption best evidenced by the May 6, 2010 "Flash Crash."
The “Flash Crash”
On May 6, 2010, US stock markets opened down and trended down most of the day on worries about the debt crisis in Greece. At 2:42 pm, with the Dow Jones Industrial Average already down more than 300 points for the day, the equity market began to fall rapidly, dropping more than 600 points in five minutes for an almost 1,000-point loss on the day by 2:47 pm, and briefly erasing $1 trillion in market value. Shares of some prominent companies like Procter & Gamble and Accenture traded down as low as a penny or as high as $100,000. Twenty minutes later, by 3:07 pm, the market had regained most of the 600-point drop. The so-called ―Flash Crash‖ was the largest one-day drop on record. Nevertheless, marketwide circuit breakers in place since 1988 were not triggered, even though a number of individual securities dropped precipitously — and almost as suddenly reversed the plunge.
In the immediate aftermath of the Flash Crash, the SEC adopted single stock circuit breakers that would briefly halt trading in single stocks for which there are sudden and abnormal price gyrations. These single-stock circuit breakers paused trading in any component stock of the S&P 500 Index in the event that the price of that stock moved 10 percent or more in the preceding five minutes. The pause generally would last five minutes, and was intended to give the markets a hiatus to attract trading interest at the last price, as well as to give traders time to think rationally. Once the primary market issued the trading pause, each other exchange was also to pause trading and FINRA was to pause trading by its members in the OTC markets — including trading on alternative trading systems and by market makers. The single stock circuit breakers supplemented existing marketwide circuit breakers, which halted trading for varying periods of time if the Dow Jones Industrial Average fell 10 percent, 20 percent or 30 percent from the previous day's closing price. The new circuit breakers adopted in June 2012 are intended as a more targeted, appropriately calibrated, mechanism that will not depend on overall market declines.
“Limit Up-Limit Down” for Individual Stocks
The new single stock circuit breakers prevent trades in individual listed equities from occurring outside of a specified price band, which is set at a percentage level above and below the average price of the security over the immediately preceding five-minute period, rather than halting trading entirely. Price bands for each security will be set and reset throughout the trading day at a percentage above and below the security’s average price over the prior five minutes of trading, but will not be reset if price movements within the period are 1 percent or less. The percentage level price band varies. For more liquid securities — those in the S&P 500 Index, Russell 1000 Index and certain exchange-traded products — the level is 5 percent, and for other listed securities the level is 10 percent. These percentages are doubled during the opening and closing periods, and broader price bands apply to securities priced $3 per share or less. If the market’s best bid or offer quotations are at the far limit of the price band for more than 15 seconds -- that is, if new orders do not enter the market during this period that move the best bid-offer away from, but still within the limits — trading in that security is halted for five minutes. During that timeout period, traders presumably could assess whether the move was based on fundamentals.
To implement the new circuit breakers, all market centers, including exchanges, automated trading platforms, and broker-dealers executing trades internally, must establish policies and procedures to prevent trades from occurring outside the applicable price bands, honor any trading pause, and otherwise comply with procedures in the plan.
Revised Market-Wide Circuit Breakers
Marketwide circuit breakers have been a feature of U.S. securities and financial futures markets since 1988, when they were adopted in the aftermath of the 1987 market break, which was attributed to a significant degree to runaway automated program trading. These circuit breakers are based on market decline percentage thresholds, set quarterly. The marketwide circuit breakers provided for cross-market trading halts during a severe market decline as measured by a single-day decrease in the Dow Jones Industrial Average (DJIA). Three circuit breaker thresholds — 10 percent, 20 percent and 30 percent — were set by the markets at point levels calculated at the beginning of each quarter. The formulas for these thresholds are set forth in the New York Stock Exchange (NYSE) Rule 80B. The marketwide circuit breakers were triggered only once, in 1997. Newly adopted changes lower the percentage decline threshold for triggering a market-wide trading halt and shorten the amount of time that trading is halted. The June 2012 revised marketwide circuit breaker rules change the existing rules by:
- Reducing the market decline percentage thresholds to 7 percent, 13 percent and 20 percent from the prior day’s closing price, rather than declines of 10 percent, 20 percent or 30 percent; and
- Shortening the duration of trading halts that do not close the market for the day to 15 minutes, from 30, 60 or 120 minutes.
The new marketwide circuit breakers use the broader S&P 500 Index rather than the Dow Jones Industrial Average as the pricing reference to measure a market decline, and trigger thresholds will be recalculated daily rather than quarterly. Additionally, while former marketwide circuit breakers involved six trigger time periods, the new rules provide only two trigger periods – those that occur before 3:25 p.m. and those that occur after 3:25 p.m.
Announcing approval of the limit up-limit-down mechanism, and new marketwide circuit breakers, SEC Chair Mary L. Shapiro stated: ―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.‖ Although securities traders generally favored the ―limit up-limit down‖ for individual stocks when it was proposed, there are meaningful criticisms. Some say the plan is too complicated, and that retail investors will be confused. Others, such as The Securities Industry and Financial Markets Association (SIFMA) have argued that the 15 -second ―limit state‖ is too long, and that it will cause uncertainty for traders. Others have argued that the limit state is too short — that 15 seconds is not a sufficient amount of time for most investors to digest information about a limit state condition and react to the information. There are also concerns for the impact of the rule on opening and closing periods for stocks.
With these and other criticisms in mind, the new rules will be implemented on a one-year pilot basis. SEC Chairman Shapiro made clear that during the pilot period the SEC, along with the exchanges and FINRA, would closely monitor the operation of the new limit up-limit down and market-wide circuit breaker processes to make certain that any rules approved on a permanent basis will be as effective as they can be. One thing is certain — the high-speed, technology-driven Flash Crash produced fears that it could happen again, at any time, and market participants were left reeling. The new individual stock and marketwide circuit breaker rules are complicated further steps in the learning process began with the wake-up call of October 1987, followed in 1988 when the first automated ―brakes‖ were established to address excessive volatility, and then again in 2010 in the immediate aftermath of the Flash Crash. The new measures may make markets safer by forcing some opportunity for rationality in market prices. It remains to be seen, however, whether fundamental structural issues in increasingly fragmented markets, particularly relating to high-speed trading, will be effective.