SEC Approves Proposals to Address Extraordinary Volatility in Individual Stocks and Broader Stock Market

The Securities and Exchange Commission has approved two proposals submitted by the national securities exchanges and the Financial Industry Regulatory Authority (FINRA) that are designed to address extraordinary volatility in individual securities and the broader U.S. stock market.

One initiative establishes a “limit up-limit down” mechanism that prevents trades in individual exchange-listed stocks from occurring outside of a specified price band. When implemented, this new mechanism will replace the existing single-stock circuit breakers that the Commission approved on a pilot basis after the market events of May 6, 2010.

The second initiative updates existing market-wide circuit breakers that when triggered, halt trading in all exchange-listed securities throughout the U.S. markets. The existing market-wide circuit breakers were adopted in October 1988 and have been triggered only once, in 1997. The changes lower the percentage-decline threshold for triggering a market-wide trading halt and shorten the amount of time that trading is halted.

The exchanges and FINRA will implement these changes by February 4, 2013. On Thursday, the Commission approved both proposals for a one-year pilot period, during which the exchanges, FINRA, and the Commission will assess their operation and consider whether any modifications are appropriate.

“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," said SEC Chairman Mary L. Schapiro. “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. The Commission, along with the exchanges and FINRA, will be closely monitoring the operation of the new limit up-limit down and market-wide circuit breaker processes during the pilot period to make sure any rules approved on a permanent basis are as effective as they can be."

“Limit Up-Limit Down” Plan for Individual Securities

The “limit up-limit down” mechanism, established jointly by the exchanges and FINRA, prevents trades in individual listed equity securities from occurring outside of a specified price band, which would be set at a percentage level above and below the average price of the security over the immediately preceding five-minute period. For more liquid securities — those in the S&P 500 Index, Russell 1000 Index, and certain exchange-traded products — the level will be 5 percent, and for other listed securities the level will be 10 percent. The percentages will be doubled during the opening and closing periods and broader price bands will apply to securities priced $3 per share or less.

To accommodate more fundamental price moves, there would be a five-minute trading pause, similar to the pause triggered by the current circuit breakers, if trading is unable to occur within the price band for more than 15 seconds.

Under the new plan all trading centers, including exchanges, automated trading venues, 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 the procedures set forth in the plan.

Updated Market-Wide Circuit Breakers

The revised market-wide circuit breaker rules update the existing rules by:

• Reducing the market decline percentage thresholds needed to trigger a circuit breaker to 7, 13, and 20 percent from the prior day’s closing price, rather than declines of 10, 20, or 30 percent.
   
• Shortening the duration of trading halts that do not close the market for the day to 15 minutes, from 30, 60, or 120 minutes.
   
• Simplifying the structure of the circuit breakers so that there are only two relevant trigger time periods, those that occur before 3:25 p.m. and those that occur on or after 3:25 p.m. The two periods replace the current six-period structure.
   
• Using the broader S&P 500 Index, rather than the Dow Jones Industrial Average, as the pricing reference to measure a market decline.
   
• Requiring the trigger thresholds to be recalculated daily rather than quarterly.

The market-wide circuit breakers were not triggered during the severe market disruption of May 6, 2010, which led the exchanges and FINRA, in consultation with SEC staff, to assess whether the circuit breakers needed to be updated in light of today’s market structure. In addition, the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues recommended in February 2011 that the SEC and CFTC review the current operation of the market-wide circuit breakers, and consider appropriate modifications.

Additional Measures

In addition to the single-stock circuit breaker pilot program, the SEC has undertaken other initiatives in the wake of May 6, including:

• Approving new exchange and FINRA rules clarifying how and when erroneous trades would be broken.
   
• Approving new exchange and FINRA rules to strengthen the minimum quoting standards for market makers and effectively prohibit “stub quotes” in the U.S. equity markets.
   
• Adopting a rule requiring broker-dealers to have risk controls in place before providing their customers with access to the market.
   
• Adopting a rule establishing a large trader reporting system to enhance the Commission’s ability to identify large market participants and collect information on their trading activity.

The SEC staff also is considering what additional measures may be needed, including establishing a consolidated audit trail system to better track orders and trades in securities across the national market system.