Back in October 19, 1988, in response to Black Monday from a year earlier (the SEC is not known for fast turnaround times) a little known SEC rule came into effect, known as Rule 80B, and somewhat better known as "Trading Halts Due to Extraordinary Market Volatility" which set trigger thresholds for market wide circuit breakers - think a wholesale temporary market shutdown. According to Rule 80B (as revised in 1998), the trigger levels for a market-wide trading halt were set at 10%, 20% and 30% of the DJIA. The halt for a 10% decline would be one hour if it occurred before 2 p.m., and for 30 minutes if it occurred between 2 and 2:30, but would not halt trading at all after 2:30. The halt for a 20% decline would be two hours if it occurred before 1 p.m., and between 1 p.m. and 2 p.m. for one hour, and close the market for the rest of the day after 2 p.m. If the market declined by 30%, at any time, trading would be halted for the remainder of the day. Needless to say, a 30% drop in the market in our day and age when the bulk of US wealth is concentrated in the stock market, would be a shot straight to the heart of the entire capitalist system. Which is why the smallest gating threshold is and has always been the key.
However, despite the revision, as anyone who traded stocks on that fateful day in May knows, the market-wide circuit breakers were completely ineffective and unused during the HFT-induced and ETF-facilitated flash crash of May 6, 2010. In turn, the SEC's flash crash response was to implement individual stock-level circuit breakers which however, instead of restoring confidence in the market, have become the butt of daily jokes involving freaked out algos. This was merely the most recent indication of how horribly the SEC's attempts to "regulate" a market it no longer has any grasp or understanding of, backfire on it.
However, even that may pale in comparison to just how badly the SEC may have blundered yesterday afternoon, when it proposed yet another revision to its market-wide halt rule. And once again, instead of making traders and investors more comfortable that the SEC is capable and in control, the questions have already come pouring in: is the SEC preparing for another massive market crash?
This is what hit the tape from the SEC late yesterday [12]:
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.
The key word is bolded and underlined: lower. Because as noted above, the upped market-close threshold is irrelevant: should the S&P trade down to 800 on Monday, western civilization will have far bigger problems to worry about than reversing a market crash. It is the tiniest quantized increment that is relevant. Which according to the SEC is now a "mere" 7% to enact a market holiday, either temporary or indefinite.
This is how the market-wide circuit breaker language will look going forward:
- 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.
Additional, the SEC also adopted less relevant single-stock trading halts. Think Italian stock market where financial firms trade either limit up or limit down day after day now for months. Surely that helps restore confidence in the market:
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.
In the grand scheme of things, the stock limit mechanisms are irrelevant. They never worked before, and will not work in the future. Perhaps if the SEC really cared about restoring some single-stock level confidence it would consider implementing the stub trade ban which allegedly prevents idiotic executions from taking place, yet which as Nanex shows us on a daily basis, happens all the time with exchanges gaming every possible loophole.
What is relevant, and what is very disturbing, is why did the SEC just lower the band from 10% to 7%: why 7%? And why now? What is even more troubling is that as Bloomberg's Nina Mehta writes [13], the decision to make these changes was not made by actual traders, not by actual people who understand how broken the market is (such as those who have been banging the table on broken market structure since 2009... we are fairly confident readers know who these entities are), but... wait for it... Nobel prize winning economists!
An advisory committee to the SEC and Commodity Futures Trading Commission recommended changing the marketwide system. The advisers included Joseph Stiglitz, an economist who won the Nobel Prize; David Ruder, a former SEC chairman; Brooksley E. Born, who was chairman of the CFTC; and John J. Brennan, chairman emeritus and senior adviser at Vanguard Group Inc.
And another entity involved, is the exchange which allowed Corzine to make off with billions in client funds, which have, since the November bankruptcy, still not been discovered:
The owner of the Chicago Mercantile Exchange is examining the SEC’s approval of the marketwide circuit breakers, Michael Shore, a spokesman for CME Group Inc. (CME), wrote in an e-mail. The company has circuit breakers for equity-index futures that are consistent with those in the stock market.
“CME Group has been a strong advocate for more appropriately calibrated marketwide circuit breaker trigger levels that are coordinated across trading venues,” Shore said. “We have commented extensively on the proposals, are currently evaluating the changes approved by the SEC and will be submitting proposed amendments to our rules in the near future.”
Surely nothing quite like getting an economist and an exchange that stood idly by as billions in client funds vaporized, together in the same room and hatching a brilliant plan to avoid shareholder losses.
The question obviously is: what does the SEC know that nobody else does? And why now, just as everyone is terrified that Europe is on the verge of an all out collapse? And just as importantly, why wait until February 2013? Why not implement now to at least avoid the potential of a total market cataclysm including potentially the game-ending 30% drop in the last hour of trading?
Basically what the SEC just did is make sure everyone has a stop loss order 7% below the prevailing NBBO. And with so little volume in markets, and with the HFT algos having nothing better to do than inflicting max pain on traders by hunting stops, primarily to the short squeeze side, but now courtesy of the SEC, to the downside as well, one can be sure the HFT-induced selling pressure to hit the market-wide "Max Pain" point will suddenly become very topical.
Our advice: have limit sell orders a few percentage points above the 7% threshold that the SEC suddenly is infatuated with. Because once they are crossed, the entire market will light up in one massive stop loss trading activation. It would also be prudent to pair trade this limit order with a limit buy just above the 20% down threshold that DKed orders during flash crash day.
In other words, thanks to the SEC's statement, and to the psychological effect of "framing" so popular to traders, down 7% in milliseconds just became the New Killing It.
We leave readers with the current chart showing the NYSE's own market-wide trading halts [14]. Learn it well.
Allow us to paraphrase the last sentence: "in the event of a 3900-point decline in the DJIA, you better be locked and loaded."