SEC Approves 'Limit Up-Limit Down' Plan To Curb Volatility In Stock Market, As High-Frequency Trading Grows

06/01/2012 04:38 pm ET | Updated Aug 01, 2012

* "Limit up-limit down" to replace single-stock circuit breakers

* Threshold for triggering market-wide trading halt lowered

* Plan to be put in place by exchanges, FINRA, by Feb. 4 (Adds background, details on plan, quote from trader)

By John McCrank

June 1 (Reuters) - U.S. securities regulators have approved a one-year pilot program for a plan designed to protect equity markets from volatile price swings in the wake of the "flash crash" of May 6, 2010.

The Securities and Exchange Commission said on Friday that beginning in February, individual U.S.-listed stocks will be prevented from trading outside a range based on recent prices.

The so-called "limit up-limit down" initiative would pause trading for five minutes for securities if attempted trades remain outside the price band for more than 15 seconds. During that timeout period, traders could assess whether the move was based on fundamentals.

"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," SEC Chairman Mary Schapiro said in a statement.

The SEC worked closely with the exchanges and the Financial Industry Regulatory Authority (FINRA) to come up with market structural fixes aimed at preventing a repeat of the flash crash, which temporarily wiped out about $1 trillion in paper value in the stock market in a matter of minutes.

For some, the unprecedented market drop confirmed fears that high-speed, automated trading represented a systemic risk to the foundations of capitalism. For others, it was an embarrassing blip that called for measured adjustments to an otherwise well-functioning market.

The new trading bands will replace existing single-stock circuit breakers, which halt trading for five minutes in U.S. stocks and exchange-traded funds (ETFs) when they move more than 10 percent in five minutes.

"Trading bands are not in and of themselves counter to market pricing and they can lend a degree of stability to a market," said Peter Kenny, managing director at Knight Capital in Jersey City, New Jersey. "It's a very logical next step."

For more liquid securities in the S&P 500 Index, Russell 1000 Index, and certain exchange-traded products, the band will be 5 percent above and below the average price of the security over the preceding five-minute period. 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.

MARKET-WIDE CIRCUIT BREAKERS

The plan also updates existing market-wide circuit breakers that, when triggered, halt trading in all exchange-listed securities on 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 revised rules tighten the market decline percentage thresholds needed to trigger the market-wide circuit breaker to 7, 13, and 20 percent from the prior day's closing price, rather than declines of 10, 20, or 30 percent.

They also shorten the duration of trading halts that do not close the market for the day to 15 minutes, from 30, 60, or 120 minutes.

The broader S&P 500 Index will be used as the pricing reference to measure a market decline, rather than the Dow Jones Industrial Average, which is currently being used.

The SEC said it approved the proposals, which have to be in place by Feb. 4, for a one-year pilot period. During that time the exchanges, FINRA, and the SEC will assess their effectiveness.

The SEC said it is also 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. (Reporting by John McCrank; Additional reporting by Jonathan Spicer and Sarah Lynch; Editing by Phil Berlowitz, Gary Hill)