Equity exchanges and regulators have grappled with the issue of extraordinary market volatility since the May 6, 2010 "flash crash" when, within minutes, many equities moved greater than 60% and several printed prices of a penny or $100,000. To further address this issue, a consortium of exchanges and the Financial Industry Regulatory Authority (Finra) has submitted a plan to the Securities and Exchange Commission (SEC) to institute a limit up-limit down mechanism on single stocks.
Shortly after the flash crash, the SEC instituted single-stock circuit breakers on a number of stocks on a trial basis. While those circuit breakers were effective, they were occasionally set off in volatile markets or by erroneous trades.
"You have to keep in mind that the circuit breaker rule was a pilot. There was a perceived need to act quickly to address the fallout from the flash crash and try to figure out what needed to be done to take that kind of volatility out of the marketplace," says Mark Costley of Drinker, Biddle & Realth. "The circuit breakers were an obvious first step, but they were never intended to be more than that. What we’re seeing now is a next step on the path to address this type of volatility."
According to the proposal, the limit up-limit down mechanism would prevent equity trades from occurring outside of a specified price band. That band would be set at a percentage level above and below the average price of the stock over the previous five-minute period. For stocks currently in the single stock circuit breaker program, the band would be at 5%; for those not in the program, it would be 10%.
While the official proposal came from the exchanges and Finra, Costley says the SEC had a hand in pushing it along and ensuring all the exchanges were on the same page, something that does not seem to happen often.
"This shows that all the marketplaces got together and worked through the issues to come up with a rule that represents a consensus among [them]," says Ed Johnsen of Winston & Strawn, LLP.
The exchanges and Finra asked that the proposal be instituted as a one-year trial program. Currently, it is in a 21-day comment period, after which the SEC will discuss it.
"Assuming the rules work as intended, investors can have a little more confidence that they are going to be trading upon the perceived value of companies rather than the risk of being caught in another extreme volatility situation having nothing to do with the underlying fundamentals," Costley says.
The plan does not state explicitly that limits would apply to both equities and equity options, but they most likely will as numerous options exhanges also have signed the rule proposal.