Will stock market circuit breakers stop another Flash Crash?

Wednesday, May 19th, 2010 By

an electrical service panel with circuit breakers

The SEC's proposed stock market circuit breakers are trading curbs that will pause activity on volatile stocks in hopes of averting another Flash Crash like the market slide on May 6. Flickr photo.

New circuit breakers for the stock market to avoid another Flash Crash were proposed by the Securities and Exchange Commission Tuesday. The new trading curbs would be applied on a trial basis to all stocks on the Standard & Poor’s Index. The SEC said the new stock market circuit breakers will pause trading in specific stocks if their prices move by 10 percent or more in five minutes. The trial will begin after a 10-day comment period and will last through Dec. 10. The proposal is a response to the unexplained market slide May 6 that drove the Dow Jones industrial average down about 700 points within minutes.

NYSE circuit breakers focus on volatile stocks

NYSE circuit breakers already in place did not trip during the May 6 Flash Crash, but those trading curbs are market-based — they don’t apply at the individual stock level. Reuters reports that regulators and the exchanges have been under intense pressure to figure out what triggered the May 6 meltdown and do something to repair the integrity of U.S. stock markets. The exact cause of the Flash Crash has yet to be determined, but a mechanism to briefly halt trading across markets for a single stock has emerged as a solution. Reuters, a European news service, adds that the new NYSE circuit breakers are similar to stricter methods used in European markets. Circuit breakers at the London Stock Exchange are based on the liquidity and volatility of individual stocks.

Flash Crash exposes stub quotes

The stock market Flash Crash on May 6 brought the market down nearly 1,000 points in a matter of hours. Traders may have started looking for cheap payday loans, and the Dow soon rebounded, but it finished the day down 347.80, or 3.2 percent, at 10,520.32. According to the New York Times, some individual stocks suffered even more than the market at large. Five exchange-traded funds — mutual funds that trade like stocks — traded for a penny or less per share. Nine others traded at 15 cents or less. Stocks traded hands for a penny a share because of what the SEC calls “stub quotes,” or placeholder bids that traders sometimes enter into the electronic system when they don’t really want to buy or sell a stock, but want to stay in the game.

New NYSE circuit breakers more equitable

Thousands of trades in hundreds of stocks were canceled as a result of having been judged as “clearly erroneous,” executed by computer before traders were able to react to what was happening in the market. Market regulators canceled any trades that took place between 2:40 and 3 p.m. that were 60 percent or more below the last trade that took place before 2:40 p.m. In the same article, Reuters reports that some investors believe that the circuit breaker on individual stocks is a more equitable approach to prevent drastic, across-the-board trade cancellations.

“The broad market circuit breakers affect everybody, and could penalize people for what could be an index move,” Lou Matrone, a sales trader at JonesTrading, told Reuters. “But the stock-based ones deal with it specifically on a case by case basis. You’re not penalizing people for trading stocks where nothing is really going on, they’re not being dragged in for a ‘fat finger’ problem or some other problem.”

SEC considers other trading curbs

During the six-month circuit breaker trial period, the New York Times reports that the SEC will also consider other trading curbs discussed during a recent Congressional inquiry into the May 6 plunge. Those included ways to address the risks of market orders, a potential ban on so-called stub quotes of one or a few cents for a stock that is trading significantly higher than that, and the use of trading pauses at various exchanges.

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