The changes represent the first policy response from the Securities and
Exchange Commission since the turmoil on May 6 and will, in effect, subject
all stocks in the S&P 500 to new speed limits.

Investors are waiting to see how the market fares under the new regime during
a planned six-month pilot period.

The dynamics of how the circuit breakers are calculated should reduce the
likelihood of many stocks being subjected to trading halts, analysts say.

Prevention
However, some are warning that the new rules will not prevent a repeat of the
chaotic trading seen last month.

During the “flash crash” some 55 S&P 500 stocks experienced price movements of
10 per cent or more from a sale in the preceding five-minute period between
2.41pm and 2.50pm, according to Execution Analytics & Compliance Solution.

Shares in Procter & Gamble, the household products group, briefly fell 35 per
cent; those of Accenture, the consulting group, slid precipitately from $40
a share to trade at the incredible price of just one cent at one point.

The new circuit breakers on stocks have been designed to prevent such wild
swings. They are based, in part, on the market’s current method whereby
trading in a stock can be halted when there is news about a company pending.

However, there are crucial differences to how circuit breakers are calculated,
which the listing exchanges must monitor. With the new circuit breakers,
halts are triggered based on where the price of the stock was trading during
the previous five-minute period.

This rolling reference price over five minutes has been designed so that the
new circuit breakers are only triggered in extreme cases of market turmoil
and do not disrupt daily swings in stocks based on specific company or
sector news.

“Circuit breakers should not be a daily occurrence, they are designed to be
triggered under extreme circumstances,” explains Joe Ratterman, chief
executive at Bats Exchange, one of the new upstart exchanges.

Favour fastest computers
However some traders argue that the new circuit breakers could favour the
fastest computer trading systems as these systems will detect slightly ahead
of others when circuit breakers are about to be triggered and will be able
to take steps to protect themselves.

Slower trading systems could be left with open positions in a halted stock.

Other critics of the new circuit breakers dispute whether the new rules will
prevent a repeat of the flash crash. Some caution that the new rules may
even exacerbate problems.

Jeffrey Rubin, director of research at Birinyi Associates, says after
analysing the data from May 6, that “the adjusted Dow Jones Industrial
Average would still have declined 500 points in five minutes despite the new
rule”.

He warns that should a stock approach the 10 per cent limit, people in the
market may decide to step away and not run the risk of trading near that
level. Should market liquidity thin under such circumstances, there is a
risk that a stock’s price rises or falls much more than 10 per cent before
the trading halt is called.

There are also execution issues that still need to be ironed out.

Pilot
During the pilot period, other stocks and securities such as exchange-traded
funds, outside the S&P 500 are likely to feature circuit breakers.

“I think the move to include ETFs will happen quite quickly,” says Eric Noll,
executive vice-president at Nasdaq OMX.

However, a 10 per cent band may not be appropriate for less liquid stocks and
ETFs.

Despite these stumbling blocks, the move towards widespread circuit breakers
appears unabated.

Nasdaq
On Wednesday, Nasdaq announced that it would be implementing its own price
curbs for all stocks listed on the exchange. The Nasdaq Volatility Guard is
designed to complement circuit breakers for S&P stocks and will start during
the third quarter.

Meanwhile, the NYSE trading floor will continue to operate its own curbs,
known as Liquidity Refreshment Points, which apply to all its listed stocks
and not just those in the S&P 500.

NYSE and Nasdaq play lead roles in coping with drama

The two main US equity exchanges where companies list their shares are NYSE
Euronext and Nasdaq OMX and they are doing the bulk of preparing the overall
market for halting trading in specific stocks, when prices change
dramatically.

In contrast, BATS and Direct Edge, the other two main public exchanges which
have risen to prominence in recent years, will only have to make small
changes to their technology systems as news of a trading halt is initiated
by the NYSE and Nasdaq.

William O’Brien, chief executive of Direct Edge, says: “Everyone will look at
how their systems operate when a trading halt is called on a stock by a
listing exchange, and I think there will be little if any incremental
changes to our technology in order to comply with the trading curbs.”

Any halt in trading and subsequent restart will be governed by NYSE and
Nasdaq, which are currently responsible for trading halts in a stock ahead
of specific company news.

They currently use auctions for the opening and closing of market prices, and
this process will be used for re-establishing trading in a halted stock.

The circuit breakers will run from 9.45am until 3.35pm and not cover big
swings at the open and close, where stocks listed on NYSE and Nasdaq are
subject to auctions designed to smooth out imbalances in trading.

“We need to leverage some of our auction technology that is used for the
market open and close, in order to be ready for the new rules,” says Joe
Mecane, co-head for US listings and cash markets at NYSE Euronext.

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