HIGH SPEED TRADING BEGETS HIGH SPEED REGULATION: SEC RESPONSE TO FLASH CRASH, RASH

David M. Serritella*
TABLE OF CONTENTS
I. II. III. A. B. C. IV. V. Introduction ................................................................................................. 433 Background ................................................................................................. 434 Analysis....................................................................................................... 435 Automation, Speed and High Frequency Trading ................................... 436 Interconnectivity and Systemic Risk ....................................................... 437 SEC Response ......................................................................................... 439 Resolution ................................................................................................... 442 Conclusion .................................................................................................. 444

I.

INTRODUCTION

On May 6, 2010, the Dow Jones Industrial Average (DJIA) underwent dramatic intraday price swings, at one point dropping over 9% from the previous days closing prices before staging a comeback which minimized the damage to a relatively sane 3.2% decline.1 Although it quickly rebounded, one stock, which had been trading at forty one dollars a share, remarkably fell all the way to one cent.2 Before the dust settled on what is now known as the Flash Crash, fingers had been pointed many different directions, liberally assigning blame for the markets intensely pendulous hurly burly.3
*

J.D., University of Illinois College of Law, 2011; B.A., English, Writing, Winona State University,

1998. 1. Testimony Concerning the Severe Market Disruption on May 6, 2010 Before the H. Subcomm. on Capital Mkts., 111th Cong. (2010) (statement of Mary L. Shapiro, Chairman, U.S. Securities and Exchange Commission) [hereinafter Shapiro], available at http://www.sec.gov/news/testimony/2010/ts051110mls.pdf. 2. Matt Phillips, Accentures Flash Crash: Whats an Intermarket Sweep Order, Wall St. J. BLOG (May 7, 2010, 5:51 PM), http://blogs.wsj.com/marketbeat/2010/05/07/accentures-flash-crash-whats-anintermarket-sweep-order/. 3. See Tom Lauricella, Market Plunge Baffles Wall Street, Wall ST. J., May 7, 2010, at A1, available at http://online.wsj.com/article/SB10001424052748704370704575228664083620340.html?mod=WSJ_hps _MIDDLETopStories (last visited Oct. 12, 2010) (noting rumors blaming a clearly erroneous fat finger trade and high-frequency trading firms for the Flash Crash circulated among traders); Dan Wilchins, Fat Finger Role in Selloff Likely a Myth, Reuters (May 7, 2010), http://www.reuters.com/article/ idUSN0712750420100507 (The rumors about what happened on Thursday varied, but typically involved a trader selling $16 billion of a futures contract or exchange-traded fund, when he or she meant to sell $16

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While its ensuing investigation has yet to yield a definitive singular cause of the Flash Crash4and, indeed, it may neverthe SEC nonetheless responded with new rules unifying and tightening the system of market checks which had previously been separately yet cooperatively controlled by various private actors.5 One cannot fault regulators for responding so expediently to the Flash Crash as that days events exposed dangerous fractures in our markets foundations.6 Unfortunately, the SEC reaction may be as flawed as the system it seeks to protect. This article examines the new SEC rules against the backdrop of the current market characteristics which likely contributed to the Flash Crash. Part II provides an overview of the Flash Crash. Part III analyzes the special threats posed by the current market practices of automated high speed and high frequency trading and the SEC response to them. Finally, Part IV suggests areas in which the new SEC rules should be refined before becoming permanent. II. BACKGROUND On May 6, 2010, the market opened amid concern about Greeces precarious financial situation, U.K. elections and an upcoming jobs report, among other worries.7 By 11:00 a.m. Eastern Standard Time (hereafter all references to time are Eastern Standard Time), the DJIA was down sixty points on heavy selling volume.8 Notably, one metric commonly used to gauge selling was at its highest level since the day the market reopened following the September 11, 2001 terrorist attacks.9 By 2:00 p.m., the DJIA had lost 161 points, or about 1.5% of its value.10 Shortly thereafter, the Flash Crash played

million.); Stephen Simpson, What Caused the Flash Crash?, Financial Edge (June 18, 2010, 11:04 AM), http://financialedge.investopedia.com/financial-edge/0610/What-Caused-The-Flash-Crash.aspx (dispelling rumors blaming rogue traders or cyber terrorism, among others). 4. See, COMMODITY FUTURES TRADING COMMN & SEC, Preliminary Findings Regarding the Market Events of May 6, 2010, 27 (May 18, 2010), available at http://www.sec.gov/sec-cftc-prelimreport.pdf (listing several possible causes of or contributing factors in the Flash Crash) [hereinafter PRELIMINARY FINDINGS]; Shapiro, supra note1 (At this point, we are unable to point to a single event which could be the sole cause. . . . Ultimately, we may learn that the extraordinary disruption in trading, however it may have been triggered, was the result of a confluence of events which, taken together, exacerbated what already had been a down day and led to an extraordinarily steep price drop and recovery.). 5. SEC, RELEASE NO. 34-62252, ORDER GRANTING ACCELERATED APPROVAL TO PROPOSED RULE CHANGES RELATING TO TRADING PAUSES DUE TO EXTRAORDINARY MARKET VOLATILITY (June 10, 2010), http://www.sec.gov/rules/sro/bats/2010/34-62252.pdf [hereinafter RULES]. 6. See, Edward Wyatt, S.E.C. Approves Market Circuit Breakers, NY Times, June 10, 2010, http://www.nytimes.com/2010/06/11/business/11circuit.html?_r=1&dbk (The Flash Crash raised questions about the safety and soundness of equity trading markets, which have changed dramatically in the last few years by moving to multiple electronic platforms.); Shapiro, supra note 1 at 8 (At a meeting of the SEC and leaders of six markets there was a strong consensus that the type of aberrational volatility experienced on May 6 is not appropriate in our markets.). 7. Shapiro, supra note 1. 8. Scott Patterson & Tom Lauricella, Did a Big Bet Help Trigger Black Swan Stock Swoon?, Wall St. J., May 10, 2010, at C2, available at http://online.wsj.com/article/ SB10001424052748704879704575236771699461084.html. 9. Id. 10. Shapiro, supra note 1.

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itself out in a flurry of trading.11 Between 2:30 and 3:00 p.m., the market experienced some of the most violent whipsaws in recent memory.12 By 2:42 p.m., the DJIA was down 3.9%, extending the relatively gradual losses incurred earlier in the day.13 Within the next five minutes, the DJIA abruptly shed an additional 573.27 points (another 5.49%), extending the days losses to 9.16%.14 This represented, roughly, the low point in the day, as the market suddenly reversed itself, reclaiming 543 points in a minute and a half.15 By 3:00 p.m., the DJIA had reduced its total losses on the day to 4.26% (463.05 points).16 At market close, the DJIA was down a total of 3.2% from the previous day, having lost 347.8 points and standing at 10,520.32.17 As wild as the DJIAs ride through the Flash Crash was, it was relatively tame when juxtaposed with the movement of several individual stocks. For instance, 3M and Procter & Gambletwo of the DJIAs thirty component stockslost approximately 21% and 37%, respectively.18 Additionally, over 25% of all exchange-traded funds (ETFs)19 saw their share prices temporarily drop more than 50 percent during the frantic hour.20 Further, after the market closed, the exchanges agreed to cancel any trades effected from 2:40 p.m. to 3:00 p.m. at prices 60% away from the last trade at or before 2:40 p.m.21 As a result, trades in 326 different securities were retroactively cancelled.22 III. ANALYSIS The SEC investigation of the Flash Crash has identified several factors, the confluence of which likely caused the turmoil.23 The factors that this article focuses on are simply the prevailing trading methods and characteristics of professional traders in the current market structure and the interconnectivity of market participants.24 Accordingly, this Part examines these market
11. See id. (summarizing the trading on May 6, 2010). 12. See id. (describing the point changes between 2:30 and 3:00). 13. Id. 14. Id. 15. Id. 16. Id. 17. Id. 18. Id. 19. An ETF is [a] security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold. Definition of Exchange-Traded Fund, INVESTOPEDIA, http://www.investopedia.com/terms/e/etf.asp (last visited Oct. 12, 2010). 20. Shapiro, supra note 1. 21. Id. 22. PRELIMINARY FINDINGS, supra note 4, at 29. 23. See PRELIMINARY FINDINGS, supra note 4, at 5 (pointing to disparate exchange practices, stop-loss orders, short sales and a lack of liquidity as potential factors); Shapiro, supra note 1 (Ultimately, we may learn that the extraordinary disruption in trading, however it may have been triggered, was the result of a confluence of events which, taken together, exacerbated what already had been a down day and led to an extraordinarily steep price drop and recovery.). 24. See generally Shapiro, supra note 1 (discussing the nature of trading in the current market structure, the interconnectivity of markets, and their effects on liquidity as areas the SEC needs to address in any

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characteristics, the systemic risks that accompany them, and, finally, the SEC response to the Flash Crash. A. Automation, Speed and High Frequency Trading Technology assists traders in many ways, including transactional tools such as the means to make real-time securities trades electronically as well as the ability to employ sophisticated algorithmic trading strategies25 and automated execution programs to profit from high frequency trading (HFT).26 As exemplified by the shrinkage of the traditional pit-trader model at the New York Stock Exchange (NYSE),27 the general trend is toward increased reliance on technology to drive trading.28 Automation provides many advantages to the exchanges and other trading centers including the ability to facilitate more transactions than ever before, risk management benefits, enhanced efficiency, and a reduction in trading errors and costs.29 Automation is a crucial element in HFT.30 HFT, though not clearly defined, refers to professional traders acting in a proprietary capacity31 that engage in strategies that generate a large number of

response to the Flash Crash). 25. See, e.g., TELLEFSEN CONSULTING GROUP, INC., ALGORITHMIC TRADING TRENDS AND DRIVERS, (2005), http://www.tellefsen.com/Algorithmic_Trading_TCG.pdf (discussing the ubiquity of algorithm-based trading strategies among major institutional investors) (last visited Oct. 12, 2010); see also Mara Der Hovanesian, Cracking the Streets New Math: Algorithmic Trades Are Sweeping the Stock Market. But How Secure Are They?, Bloomberg Business Week (Apr. 18, 2005), http://www.businessweek.com/ magazine/content/05_16/b3929113_mz020.htm ([A]n algorithm . . . is a series of calculated steps strung together to produce a desired numeric goal. Now, these formulas are used to buy and sell large blocks of stock that have been traditionally shopped around traders on the floor of the NYSE or through Wall Street brokers.); Algorithmic Trading Definition, INVESTOPEDIA http://www.investopedia.com/terms/a/ algorithmictrading.asp (last visited Oct. 12, 2010). 26. See, e.g., PRELIMINARY FINDINGS, supra note 4, at 73 (Many proprietary trading firms engage in automated strategies that continually monitor the various markets and products for disparities in prices. When the trading systems for these firms spot such disparities, they can generate in microseconds an enormous volume of orders that are intended to capitalize on these disparities.). 27. Anupreeta Das, NYSEs Sparsely Populated Trading Floor to Shrink, REUTERS (Sept. 12, 2007), http://www.reuters.com/article/idUSN1225559120070912. 28. See, e.g., Jerry W. Markham & Daniel J. Hardy, For Whom the Bell Tolls: The Demise of Exchange Trading Floors and the Growth of ECNs, 33 J. Corp. L. 865, 866 (20072008) (Exchange trading floors are fast fading into history as the trading of stocks and derivative instruments moves to electronic communications networks (ECNs) that simply match trades by computers through algorithms.). 29. Concept Release on Equity Market Structure, 75 Fed. Reg. 3594, 3598 (Jan. 21, 2010) (to be codified at 17 C.F.R. pt. 242) [hereinafter Concept Release], available at http://www.sec.gov/rules/ concept/2010/34-61358fr.pdf. The automation of trading centers is believed to foster the democratization of securities trading by preserving the anonymity of buyers and sellers, as trade-matching algorithms bring buyers and sellers together electronically, ameliorating concerns of privileged market access for some participants. Markham, supra note 28, at 899. See also PRELIMINARY FINDINGS, supra note 4, at app. A-3 (The registered exchanges all have adopted highly automated trading systems that can offer extremely high-speed, or lowlatency, order responses and executions. The average response times at some exchanges, for example, have been reduced to less than 1 millisecond.). 30. See Shapiro, supra note 1 (Given the competitive pressures to maximize their speed of trading, HFT firms typically will attempt to streamline the code for their trading algorithms.); PRELIMINARY FINDINGS, supra note 4, at app. A-10 (Highly automated trading systems have helped enable a business model for [HFT firms].). 31. Proprietary trading refers to when a firm trades for direct gain on its own behalf rather than to earn a commission. Investopedia, Dictionary: Proprietary Trading, http://www.investopedia.com/terms/p/

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trades on a daily basis.32 A variety of proprietary firms practice HFT, based on the SECs broad definition, commonly exhibiting the following characteristics: (1) utilization of high-speed, complex computer programs and equipment to effect trades; (2) utilization of co-location services to reduce latencies; (3) extremely small time-frames for opening and closing positions; (4) placing numerous orders and quickly cancelling them; and (5) ending the trading day in as close to a flat position as possible.33 Currently, HFT is estimated to comprise about 50% of all trading activity by volume in equity markets34 and represents a significant source of liquidity.35 In addition to the temporal edge garnered them via their heavy investments in technology, many proprietary HFT firms are also able to minimize latencies as a result of proximal advantages.36 Specifically, colocation services allow market participants to rent space from trading centers, allowing the former to place its servers in close proximity to the latters ordermatching engines.37 The increase in speed afforded by automated trading, enhanced technology and co-location enables proprietary HFT firms to execute over a million trades in a day.38 The SEC suspects that HFT played a significant role in the Flash Crash.39 B. Interconnectivity and Systemic Risk The speed of automated trading carries with it risks of cataclysmic consequences for the entire market.40 This is largely the result of the interconnectivity of financial markets and their participants, as well as increased interconnections between securities and their derivatives.41 Essentially, market activity for a large swath of investors depends directly on prices that may or may not have any direct relation to the security or derivative
proprietarytrading.asp (last visited Oct, 12, 2010). 32. Concept Release, supra note 29, at 3606. 33. Id.; Shapiro, supra note 1. 34. Shapiro, supra note 1. 35. Concept Release, supra note 29, at 360708. 36. See, e.g., id. at 3610 (Co-location is one means to save micro-seconds of latency.). 37. Co-location is believed to aid the renters speed in both an absolute and a relative sense, as, in addition to it reducing time-lag between servers, it provides a brief yet often crucial informational advantage over other market participants. See id. (mentioning the competitive advantages of co-location). 38. PRELIMINARY FINDINGS, supra note 4, at app. A-1011; Shapiro, supra note 1, at 1011. See also Citadel Investment Group, LLC. v. Teza Technologies, LLC, No. 09 CH 22478, 2009 WL 3416124, at *14 (Ill. Cir. Ct. Oct. 16, 2009) (High speed computer infrastructure is critical to the high frequency business because processing and execution speed are extremely important to successful high frequency trading). 39. See Shapiro, supra note 1 (discussing initiatives to prevent future occurrences of the events of May 6 and noting the dominant role of HFT in todays market structure). 40. See Tom Lauricella, Kara Scannell, and Jenny Strasburg, Investors, Regulators Laid Path to Flash Crash, Wall St. J., Sept. 29, 2010, available at http://online.wsj.com/article/ SB10001424052748704791004575520363764665240.html (blaming the Flash Crash in part on SEC regulations which helped foster an environment of high speed trading). See also Shapiro, supra note 1 (Although developments in the markets and in technology may help speed access to market data, they also greatly complicate our efforts to analyze the complex web of trading arrangements and market dynamics . . . .). 41. Michael Corkery, SEC Chairman Admits: Were Outgunned By Market Supercomputer, Wall ST. J., May 11, 2010, available at http://blogs.wsj.com/deals/2010/05/11/sec-chairman-admits-were-outgunned-bymarket-supercomputers; Shapiro, supra note 1.

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involved in a given transaction.42 Because algorithmic program trading relies on pre-set triggers which tell the computer program when to execute a given trade, if certain statistical thresholds are met, regardless of whether the occurrence is only momentary, many subsequent trades may obtain.43 These subsequent trades have the potentialwhich increases with their volumeto perpetuate themselves, thus sustaining and adding to the momentum of whatever statistical movement, usually price, tripped the triggers in the first place.44 This has the potential to harm individual investors both directly and indirectly and seems to have contributed to the Flash Crash.45 Many individual long-term investors have stop-loss orders in place for the investment products they own.46 A stop-loss order signifies the price at which an investor is not willing risk selling below.47 Typically, stop-loss orders are entered at prices significantly lower than the security trades for at the time of order-entry and are intended to be long-term safety mechanisms to appropriately manage risk.48 As soon as prices trigger the stop-loss order, the security is sold automatically, regardless of whether the drop represents but one step in a downward trend or is just a momentary blip.49 If it is part of a downward trend, the stop-loss order did its job and cut off the loss at a predetermined level. However, if the trigger was only reached because of some brief price swing, then the investor has sold a security at a less than optimal price with the inability to rebuy at a similar price, creating losses for which there is no rational basis. HFT firms use of algorithmic program trading has the potential to negatively affect short-term liquidity.50 HFT firms use risk models which determine when market activity presents too significant a risk to deploy capital.51 Since HFT firms are an increasingly important source of market liquidity, when they pull back and park their massive capital on the sidelines, for whatever reason and however briefly, liquidity falls and, accordingly, so do prices.52 The SEC suspects that just such a pullback by HFT firms contributed

42. PRELIMINARY FINDINGS, supra note 4, at 2. See Shapiro, supra note 1 (stating that transactions in a singular stock can have effects on not only other stocks in milliseconds.). 43. E.g., Matthew Goldstein, Stock plunge raises alarm on algo trading, RUETERS (May 7, 20108:31 AM), http://www.reuters.com/article/idUSTRE64631Y20100507 (last visited Oct. 12, 2010); see also Shapiro, supra note 1 (Orders in one stock directed to one market can now ricochet to other markets and trigger algorithmic executions in other stocks and derivatives in milliseconds.). 44. See, e.g., Goldstein, supra note 43 (explaining that algorithmic trading may push stocks into downward spirals, causing market chaos). 45. See, e.g., id. (suggesting that algorithmic trading sent the stocks of some prestigious companies into freefall during the Flash Crash). 46. See id. at 7 (discussing the usefulness of stop-loss orders). 47. See id. (noting such an order instructs a broker to sell a stock if it falls to a certain price). 48. See id. (discussing stop-loss orders ability to manage risk). 49. Id.; PRELIMINARY FINDINGS, supra note 4, at 7. 50. HFT provides a welcome source of liquidity, which is encouraged and rewarded by the trading centers in the form of liquidity rebates. Likewise, liquidity rebates, have in turn become a significant source of revenue for HFT firms. Concept Release, supra note 29, at 3607. 51. PRELIMINARY FINDINGS, supra note 4, at 2628. 52. Id.; Shapiro, supra note 1.

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to the Flash Crash.53 Another threat to the liquidity provided by HFT firms is that, if many of these firms engage in similar or interdependent strategies and one fails, there is the potential for enough of these firms to suffer losses of sufficient significance to reduce the pool of liquidity altogether.54 The interdependence of the liquidity provided by HFT firms is a microcosm of the interconnectivity of market participants generally.55 This is especially true when combined with the pervasiveness of algorithmic trading and automation, which opens the door for a domino effect whenever short term liquidity is threatened.56 As demonstrated by the Flash Crash, this chain of events wherein one error triggers another is not unrealistic. C. SEC Response The SEC has been quick to react to the Flash Crash, determined to avoid such market disruptions in the future.57 On June 10, 2010, the SEC published new rules (Rules), which require trading centers to halt trading in certain individual securities and derivatives if pricing thresholds are reached.58 Until December 10, 2010, the Rules are in a pilot period so that they may be adjusted and expanded.59 After the Flash Crash, many trades executed at irrational levels were later cancelled by the exchanges under an agreement reached between them, minimizing some of the damage.60 However, braking trades retroactively creates its own harms, such as upsetting repose. Further, while effective
53. PRELIMINARY FINDINGS, supra note 4, at 5 (noting that whether these firms withheld liquidity on the basis of risk models or not, they were under no affirmative obligation to provide it); Corkery, supra note 41, at 38. 54. See Concept Release supra note 29, at 3611 (To the extent that proprietary firms obtain financing for their trading activity from broker-dealers or other types of financial institutions, the significant losses of many proprietary firms at the same time also could lead to more widespread financial distress.). 55. See supra note 39 and accompanying text; see also Shapiro, supra note 1 (Orders in one stock directed to one market can now ricochet to other markets and trigger algorithmic executions in other stocks and derivatives in milliseconds.); PRELIMINARY FINDINGS, supra note 4, at 4 ([M]arkets are closely linked by a complex web of traders and trading strategies. The precipitous decline in price in one market on May 6 may have influenced a sustained series of selling in other financial markets. The rapid rebound in price in one market could similarly have been linked to a rebound in price in another.). 56. PRELIMINARY FINDINGS, supra note 4, at 4; see also, Simpson, supra note 3 ([A] sudden drop in liquidity can be very bad for prices[,] and morale and prices can fall precipitously.). 57. The SEC published its new Rules slightly over a month after the Flash Crash and did so in an expedited manner in order to prevent a recurrence of the May 6, 2010 market disruptions. RULES, supra note 5, at 4. The Commission believes that accelerating approval of these proposals is appropriate as it will enable the Exchanges nearly immediately to begin coordinating trading pauses across markets in the event of sudden changes in the value of the S&P 500 Index stocks. Id. at 12. The Commission was concerned that events such as those that occurred on May 6 can seriously undermine the integrity of the U.S. securities markets. Accordingly, it is working on a variety of fronts to assess the causes and contributing factors of the May 6 market disruption and to fashion policy responses that will help prevent a recurrence. Id. at 4. 58. RULES, supra note 5, at 56. 59. Id. at 5. 60. See PRELIMINARY FINDINGS, supra note 4, at 29 (Trades were broken in 326 individual securities, consisting of those that experienced a very severe price move of 60% or greater during the Flash Crash.). Before and during the Flash Crash, the exchanges had the ability to cancel trades under their various error trade policies if they were determined to have been executed at clearly erroneous prices. E.g., SIFMA Releases Policy Statement and Guidelines Regarding Error Trade Policies for Interdealer Brokers, SEC. INDUS. & FIN. MKT. ASSOC. (Dec. 20, 2006), http://www.sifma.net/story.asp?id=2730.

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toward undoing isolated aberrational trades after their occurrence, error trade policies are impotent against the type of severe directional pressure that wreaked havoc in the Flash Crash.61 The SEC has thus focused on the means of stopping irrational trades before they lead to a domino effect of market upheaval and erosion of investor confidence.62 The new Rules tighten the thresholds and, for the first time, centralize the control of circuit breakers.63 Circuit breakers simply refer to the ability of exchanges to temporarily halt trading in a security or derivative to avert selloffs during periods of extreme downward pressure, or to close the markets before the end of the normal trading day.64 While, previously, the exchanges each controlled their own circuit breakers, they all generally adhered to the thresholds and formulas set forth in NYSE Rule 80B.65 Rule 80B has three different thresholds10%, 20% and 30%each of which is tied to the DJIA and if met would result in a time out to market activity altogether on any exchange to execute a circuit breaker mechanism.66 Despite the extreme price movements of May 6, 2010, the circuit breakers lowest threshold was not met, as, at its worst point in the Flash Crash, the DJIA was down 9.16%lower than the 10% drop required to trigger the circuit breakers under Rule 80B.67 The SEC, recognizing that using the DJIA as a benchmark for circuit breakers may obscure extreme price movements in individual securities or derivatives, has extended the utility of circuit breakers to target individual securities and derivatives.68 Under the new Rules, the exchanges are required to issue five minute trading halts in a security if the price of that security moves at least 10% in either direction from its price in the preceding five minute period.69 To avoid interfering with the openings and closings of markets, these requirements are only in force from 9:45 a.m. to 3:35 p.m.70 The Rules do not displace Rule 80Bs mandates, rather they supplement their preexisting coverage with the ability to target individual securities whose volatility may not have enough of an effect on the DJIA to otherwise trigger a circuit breaker.71 The SEC has proposed its new Rules in order to further the policy goals

61. Error trade policies are only able to undo clearly erroneous trades retroactively, not stop them from occurring. 62. RULES, supra note 5, at 1112. (The Commission believes the proposed rule changes, among other things, will establish consistent, market-wide trading pauses as a means to prevent potentially destabilizing price volatility and will thereby help promote the goals of investor protection and fair and orderly markets.) 63. SEC to Publish for Public Comment Proposed Rules for Clearly Erroneous Trades, SEC (June 17, 2010), http://www.sec.gov/news/press/2010/2010-104.htm; Circuit Breakers and Other Market Volatility Procedures, SEC, http://www.sec.gov/answers/circuit.htm (last modified Oct. 7, 2008). 64. Id. 65. NYSE Rule 80B, http://www.nyse.com/press/circuit_breakers.html. 66. Id. 67. Shapiro, supra note 1. 68. See, e.g., RULES, supra note 5, at 4 (noting that during the Flash Crash many trades were executed at prices more than 60% away from pre-decline prices and were [later] broken by the Exchanges.). 69. Id. at 45. 70. Id. at 5. 71. See Shapiro, supra note 1 (noting that despite many trades having been executed at clearly erroneous prices during the Flash Crash, none of the circuit breakers thresholds were reached).

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of the Securities Exchange Act,72 which calls for promoting the efficiency and integrity of the markets and protect[ing] investors and the public interest.73 The SECs logic is that by forcing a time-out on the market as to a given security, investors will have a moment to regroup and decide what to do, rather than be forced into a snap decision in the face of a sell-off.74 However, it remains to be seen how effective the Rules are toward meeting their proffered ends. While still in their infancy, the new Rules suffer from crucial limitations which threaten their efficacy, not the least of which is that they only apply to stocks in the S&P 50075 and Russell 100076 indexes as well as select derivatives.77 In addition to the obviousthat many of the stocks most prone to volatility are not components of these venerable indexes78this limitation has the propensity to lead to bizarre and arbitrary results. For example, since the SECs new circuit breaker requirements do not only apply to all securities and derivatives, it is possible that trading could be halted in a given security while sales in one of its derivatives continue unabated, thus, frustrating the exchanges congressional mandate to promote market integrity and protect investors79 as well as fostering a disconnect between the prices of the derivativean ETF, for exampleand its underlying trading-halted security. Another potential problem is that a brief trading pause may actually enhance volatility in cases of severe movement,80 and a series of pauses may exacerbate downward pressure as market participants become rightly wary of securities in which trading has been halted, as they will have essentially been marked with a red flag by the exchanges at the behest of regulators. Additionally, stock prices often move up and down even while exhibiting an overall trend in one direction. Under the Rules, an investor may miss out on a

72. Securities Exchange Act of 1934 6(b)(5), 15 U.S.C. 78f(b)(5) (2006). 73. RULES, supra note 5, at 11. 74. See, e.g., Press Release, Sec. & Exch. Commn, SEC Approves New Stock-by-Stock Circuit Breaker Rules (June 10, 2010), available at http://www.sec.gov/news/press/2010/2010-98.htm (The pause, which would apply to stocks in the S&P 500 Index, would give the markets the opportunity to attract new trading interest in an affected stock, establish a reasonable market price, and resume trading in a fair and orderly fashion.). 75. See Standard & Poors 500 Index S&P, INVESTOPEDIA, http://www.investopedia.com/ terms/s/sp500.asp (last visited Oct. 12, 2010) (explaining what the S&P Index contains). 76. Russell 1000 Index Membership List, RUSSELL (June 28, 2010), http://www.russell.com/ indexes/documents/Membership/Russell1000_Membership_List.pdf. 77. Press Release, Secs. & Exch. Commn, SEC Approves Rules Expanding Stock-by-Stock Circuit Breakers and Clarifying Process for Breaking Erroneous Trades (Sept. 10, 2010) available at http://www.sec.gov/news/press/2010/2010-167.htm; Press Release, Secs. & Exch. Commn, SEC Approves New Stock-by-Stock Circuit Breaker Rules (June 10, 2010) available at http://www.sec.gov/news/ press/2010/2010-98.htm. The SEC has provided a list of included derivatives. SEC, http://www.sec.gov/ rules/sro/nysearca/2010/34-62413-ex3.pdf (last visited Oct. 15, 2010). 78. See generally Standard and Poors 500 Index, INVESTOPEDIA, http://www.investopedia.com/ terms/s/sp500.asp (last visited Oct. 12, 2010); Russell 1000 Index Definition, INVESTOPEDIA, http://www.investopedia.com/terms/r/russell_1000index.asp (last visited Oct. 12, 2010); Russell 1000 Index Membership List, http://www.russell.com/indexes/documents/Membership/ Russell1000_Membership_List.pdf (last visited June 28, 2010) (showing that the S&P 500 and Russell 1000 indexes are made up of large cap industry leading companies stock). 79. 15 U.S.C. 78f(b)(5) (2006). 80. This concern was noted by the SEC. RULES, supra note 5, at 10.

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chance to minimize a loss, as he is forced to sit on the sidelines during the trading pause at the completion of which prices may continue trending downward.81 Further, it is unknown how trading halts in some securities may affect liquidity or the market as a whole. Finally, the SEC Rules seem to overlook the fact that sometimes there is a good reason for the price of security to move 10% or more, such as a new products announcement, the release of earnings or the ouster of a CEO. Rather than letting the market determine what the effect of such developments should be, the draconian circuit breaker requirements make that decision on the basis of preset formulas; certainly not the type of flexibility required by dynamic market activity. The SEC wisely seeks to address some of the foregoing concerns by allowing the exchanges to expand the circuit breakers reach to other securities and derivatives during the pilot period if they reach agreement with each other.82 Toward those ends, the SEC has requested comments and suggestions from market participants and plans to monitor how the Rules work before the pilot period ends.83 IV. RESOLUTION The SECs proposed Rules are a much needed attempt to corral market activity into some sort of sanity during periods of extreme upheaval. However, before the Rules become officially enacted there is much room for improvement. Specifically, the SEC should study and adjust the Rules thresholds, expand the scope of the Rules to all securities and derivatives and extend the pilot period to ensure the Rules a sufficient test before enacting them permanently. Currently the Rules threshold for a trading pause is a price move of 10%.84 While a price movement of 10% in a five minute period is dramatic and may portend calamity, it may be justified. As discussed above, bad news for a company or its stock may necessitate a drop in value.85 Pausing trading simply because a stock drops 10% in value in a short period may be rash and unwarranted. The SEC needs to conduct more research on what the optimal level for these thresholds is and adjust accordingly. Another deficiency of the current thresholds is that different types of
81. Without the SECs new circuit breaker requirements, an investor may have a chance to sell a falling stock on a brief upswing, thus minimizing loss. This concern was raised to the SEC regarding the Flash Crash, with one commenter stating that a trading halt on May 6 might have increased the order imbalance preventing an intraday recovery. Id. 82. See id. at 9 (The Commission agrees that consideration should be given by the Exchanges to whether the circuit breakers should be expanded to additional securities, but does not believe that there is a reason to delay the implementation of circuit breakers for S&P 500 stocks as a reasonable first step.). 83. See id. at 910 ([T]he Commission anticipates that the Exchanges will continue to evaluate these issues during the pilot period, and will propose any modifications to the circuit breakers that may be necessary or appropriate before that period has ended . . . .). 84. Id. at 4. 85. A large settlement, a CEOs ouster, or a lackluster earnings report all may demand a reassessment of a securitys value. See supra Part III.c.

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stocks exhibit different pricing characteristics and may thus require different thresholdsa one-size-fits-all threshold is likely to be ineffective for some securities and intrusive as to others. Toward that end, the SEC should tailor its thresholds to fit the securities they apply to. It may be that thresholds based solely on pricing will be ineffectual. In addition to price-based thresholds, the SEC should consider the use of other metrics which may more accurately predict a sell-off. During the Rules pilot period, the required trading pauses only apply to securities in the S&P 500 and Russell 1000 indexes as well as certain ETFs.86 While the SECs intention is to expand the Rules to apply to other securities and to derivatives, no indication has been given as to how far they will go.87 As discussed in Part III, it makes little sense to limit the scope of rules designed to prevent volatility run amok to those securities that by their very nature are less volatile than those excluded by the Rules, such as small cap stocks. Further, the scope should be expanded to include all derivatives of included securities. Under the current rules it is not inconceivable that a security drops 10% in value while an ETF of which it is a component experiences no significant price move. While the logical inconsistency is obvious, it is unknown how this may affect markets, generally, and investors of the paused security or its derivative, specifically. While more research on this point is wise, it would be more efficient to simply expand the Rules to encompass all securities and all derivatives. There is no logical reason for protecting some investors and not others and until one is discovered, unequal treatment should not be enforced. Because so many of the potential weaknesses of the Rules88 need to be studied before they can be properly remedied, an extension of the pilot period is necessary. This is due to the fact that the only way the Rules can receive a proper test is during a period of market upheaval. Since there is no way to predict when the next period of wild volatility will occur, it is unreasonable to set such a short window of time for testing and researching. While some of these issues may be resolvable by modeling or other methods of predicting such as which metrics should be used and at what level thresholds should be setothers can only be properly tested in the crucible of extreme market conditions, such as a sell-off. There is no reason for such a short window of time in the first place. The Rules in their current state are in force, so there is no danger that prolonging the pilot period would result in less protection for investors than what they currently have.89

86. Press Release, SEC Approves Rules Expanding Stock-by-Stock Circuit Breakers and Clarifying Process for Breaking Erroneous Trades, Secs. & Exch. Commn (Sept. 10, 2010) available at http://www.sec.gov/news/press/2010/2010-167.htm. 87. RULES, supra note 5, at 6. 88. For example, it is unknown how temporary trading pauses will affect liquidity. 89. The Rules, whether in final form or that which is in force during the pilot period, offer the same level of investor protection and will equally serve the policy goal of preserving investor confidence.

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V. CONCLUSION While the SEC was right to act and to act as quickly as it did, there is no need to rush the permanent enactment of its Rules. As born out in the Flash Crash, snap-decisions and rigid rules do not necessarily lead to prudential results. The SEC should avoid the temptation to meet speed with speed and should be more deliberate than the flawed processes it seeks to correct by expanding the pilot period and doing all it can to enact the best possible Rules.