Financial Regulatory Forum

ANALYSIS-New US circuit breakers trip, stumble on problems

By Reuters Staff
July 2, 2010

By Jonathan Spicer

NEW YORK, July 2 (Reuters) – Abrupt halts in the trading of both Citigroup Inc and Washington Post Co shares over the last few weeks exposed some problems with new rules meant to avoid a repeat of the May “flash crash,” and may give traction to an alternative fix.

The halts came on separate days after erroneous trades were made in the shares, each time tripping new stock-specific circuit breakers that immediately stopped trading for five minutes.

The trades were later canceled.

But the disruptions revealed the breakers need adjustments, and some in the industry suggested they should be replaced altogether by a mechanism that would limit stocks drops without shutting down trading.

“Halting trading creates a public perception problem and in this case there was no reason for it. It was a ghost of a trade” in Citigroup, said Dave Cummings, founder and chairman of Tradebot Systems, a big Kansas City, Missouri-based automated trading firm.

The U.S. Securities and Exchange Commission had stock exchanges install the circuit breakers last month in order to soothe investor concern about the May 6 plunge, in which the Dow Jones industrial average shed some 700 points in minutes before sharply rebounding.

Cummings, who also founded BATS, now a U.S. exchange, proposed replacing the breakers with a system known as limit up/limit down. This would set ceilings and floors, refreshed regularly through the day, for stocks and effectively slow any big drops without the confusion of trade halts.

“The process of halting and reopening is much messier than when you’ve got limits,” Cummings said. “Nine times out of ten the stock is likely to bounce off the limit and come back up.”

The circuit breakers halt trading for five minutes when a stock in the Standard & Poor’s 500 index <.SPX> moves more than 10 percent in a five-minute period. They are in addition to long-standing index-based breakers that did not trip on May 6.

Although regulators and exchanges on Wednesday proposed expanding the pilot program to hundreds more stocks and exchange-traded funds, a Nasdaq Stock Market official told Reuters some tweaks need be made.

Brian Hyndman, senior vice president of transaction services at Nasdaq OMX Group Inc, added the industry is considering the limit down system, but the priority now is assessing and adjusting the still-infant breakers.

“If limit up/down is a good solution then maybe we’ll undo the circuit breaker at some point. But that’s down the road, not any time in the near future,” Hyndman said on Friday.

ERRONEOUS HALTS?

Goldman Sachs Group Inc and others have recently written the SEC endorsing a limit down system such as that used by futures exchange CME Group Inc, noting it would prevent erroneous transactions before they occur.

The halt in Citigroup shares this week came after an off-exchange trade crossed the tape 12.7 percent below the most recent price. It was entered on a Financial Industry Regulatory Authority Trade Reporting Facility, or TRF, which handles some 15 and 20 percent of all trades.

Three erroneous Washington Post trades were canceled June 16 when the newspaper’s stock more than doubled.

Hyndman said that if the TRF remains subject to the circuit breaker, so-called price overrides that allow such erroneous trades need be synced up to avoid these halts in the future.

“Things are working well, but this looks like a minor tweak that needs to be made,” he said. “We are reaching out to appropriate people to enter into those discussions.”

Regulators have not yet clearly explained what caused the flash crash, which rattled investors globally and exposed deep flaws in the high-speed electronic marketplace. Instead, they have explained it as a conflux of market events and promoted the new circuit breakers as a good safeguard.

The SEC said Wednesday it hopes to continue to expand the pilot, which expires in December. A NYSE Euronext spokesman said it is difficult to draw conclusions at this early stage, adding that the halts so far “appeared to have helped prevent additional trades taking place at the wrong prices.”

Gordon Charlop, managing director at Rosenblatt Securities, said the limit down option may ultimately prove the best option for investor confidence. “It’s good that they’re trying to address some of these issues, but it’s awfully difficult to foretell outlier situations,” he added.

(Reporting by Jonathan Spicer; Editing by Gary Hill)

((jonathan.spicer@thomsonreuters.com; +1-646-223-6253; Reuters Messaging: jonathan.spicer.reuters.com@reuters.net))

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