Flash Flood: Regulatory Structure Emerges Post-Flash Crash

Securities industry firms and trading venues are lining up behind “limit up, limit down” requirements and market-maker obligations as responses to the May 6 Flash Crash that saw prices swing wildly due to overloaded market systems. Firms are also evaluating proposals such as the Securities and Exchange Commission’s (SEC) trade-at rule governing the price at which a venue must trade in relation to the National Best Bid and Offer (NBBO) and its own displayed price, as well as consolidated audit trails, offering varying levels of support or opposition.

The SEC responded to the Flash Crash with a new circuit breaker for a trial period that runs through December 10. The Commission’s temporary circuit-breaker move left it up to the exchanges and the Financial Industry Regulatory Authority (Finra) to propose an extension that would effectively make the circuit breakers a permanent addition to the rules governing the US financial markets. The new circuit breakers are designed to halt trading in individual securities whose prices move 10 percent or more in five minutes, interrupting trading for the ensuing five minutes. In addition, SEC Rule 201—the Alternative Uptick Rule —scheduled to take effect on November 10, uses a short-sale circuit breaker to restrict prices at which securities may be sold short.

“With a 10 percent price decline from the previous close, it’s not a rolling five-minute window,” says Alison Crosthwait, director of global trading research at Instinet. “If it’s 10 percent down, there will be no more short-selling allowed on that day or the next day. This is a good measure but we will test it as it goes into play. We are a little more cautious on this one.”

In the meantime, the industry is looking for ways to operate without the need to implement these circuit breakers, says Joe Ratterman, chairman, president and CEO of Bats Trading. Limit up, limit down restrictions are one way firms can keep within the bands for the circuit breakers, and are gaining traction among market participants, according to Crosthwait.

“The only negative about limit up, limit down is that five minutes is a long time,” she says. “The Chicago Mercantile Exchange (CME) has a five-second pause, and it’s very effective. People want the minimum amount of regulation in the market and interference from rules, but they also want to be protected. Our clients, competitors and vendors all say limit up, limit down provides protection without the regulators sticking their hands in.”

Controlling the Limits
When implementing limit up, limit down, the SEC should design the limits to allow legitimate large stock-price movements, according to Stephen Bruel, analyst at TowerGroup. The SEC is considering prohibition of the use of stub quotes, which are placeholders not indicating actual trading interest, although Bruel explains that that stub quotes do support legitimate price movements.

“It’s more important to modify existing practices to meet your goals rather than implement new rules,” he says. “Perhaps looking at stub quotes is a different way of accomplishing a similar goal.”

Trading venues and the SEC are still examining the specifics and limits being used in circuit breakers. “How do you determine the bands?” says Ratterman. “The equities industry has determined a mechanism for dynamic bands already through the circuit-breaker process. There is an important distinction between what is being considered in the equity market and the futures market. We still plan to follow dynamic bands throughout the course of the day, so a stock can trend a long way from its opening price, over the course of the day. Dynamic banding raises a few questions—how do you determine what the pivot point is or the upward band?”

Ratterman suggests parameters such as bid-and-offer spreads, or highs and lows of executions from the previous five minutes. “You don’t want to see these bands flickering and creating a lot of excess activity, so maybe a weighted-average mechanism that would smooth out when the updates to these bands finally go out,” he says. “Another parameter is whether you have a de minimis move before the bands are updated.”

Making a Market
Although industry professionals do not necessarily see market-maker requirements as a remedy for the Flash Crash, raising market-maker standards is on their minds. “There are benefits to being a market-maker and that should come with additional requirements,” says Jamil Nazarali, senior managing director and head of the electronic trading group at Knight Capital Group. “Some we have suggested are quoting at the inside a certain percentage of the time, having the active liquidity within the inside. As we’ve seen at other market centers like the New York Stock Exchange (NYSE), when they have introduced economic benefits for being a market-maker, it attracts much more liquidity to the market.”

Knight Capital Group, along with Virtu Financial, an automated market-making firm, and Getco, an electronic trading and technology firm, in July submitted a proposal for market-maker obligations. The proposal includes best price, depth and maximum quoted spread obligations, as well as minimum stock requirements and higher capital requirements.

Under best-price obligations, the proposal suggests publication of continuous, two-sided attributable or non-attributable quotations, requiring market-makers to quote “at the inside” at various tier levels such as 5 to 10 percent of the time in market hours, and minimum size requirements. Under depth obligations, the proposal suggests requiring market-makers to provide three to five price levels below best-price obligation, basing price levels on factors such as volume and price.

Market-maker requirements would provide relief around short-selling, according to Nazarali. “When there is fail-to-deliver, it is very hard to provide liquidity to buyers coming to us because we know we’ll have to cover that position,” he says. “That’s the very time when you need that liquidity, when these names just don’t have a lot of volume.”

Market-makers can be expected to bridge timing gaps in trading, but not necessarily price gaps, according to Arzhang Kamarei, partner at Tradeworx, a high-frequency trading technology firm. “The definition of liquidity is the immediate availability of transactable shares at a fair price,” he says. “If buyers are not currently in the market and a seller enters with an offer around the fair price, the market-maker will step in and bid for it. They are bridging a time gap in liquidity until buyers return to the price level. However, in situations where the fair price is unknowable and there is no expectation that buyers will return to this price, markets get very volatile and adjust very quickly down to new price levels where there is demand. Market-makers should not be preventing overwhelming liquidity from determining fair market prices by artificially propping up stocks, just as they should not be artificially putting downward pressure on stocks or preventing them from rallying when there are no sellers.”

Convincing the Regulators
Ratterman cautions against market-maker requirements becoming too strict. “Technically, tightening up what it means to be a market-maker is good,” he says. “It keeps the path contained in a way that’s healthy for the market. But I worry when it goes down that path a little too far. This is in response to May 6. Convincing the public and politicians that market-maker obligations will keep another May 6 from happening is a very dangerous path. There are unintended consequences of widening the spreads and making the cost of trading go up.”

Setting tighter requirements for market-makers could create “significantly thinner markets,” adds Mary McDermott-Holland, vice president of transaction services at Nasdaq OMX. “Implementing market-maker obligations is an antidote to stopping stub quotes. Market-maker obligations are a positive, but we run the risk of promoting too many stringent obligations.”

Additional market-maker obligations could also mean additional expense, according to Crosthwait. “You’re going to have to pay them quite a bit in whatever benefit they get or however they are paid, to do things that would address the issues we saw in the Flash Crash,” she says. “We currently have a lot of traders who play a market-maker role. You need the protection that the stub quotes did not provide. That protection is really expensive. You’re going to have to pay someone to do that because it’s a lot of risk that they are going to have to take. So I think the circuit breaker is a better method than paying someone to take a huge amount of risk. That system works on a daily basis.”

The cost of being a market-maker has increased, notes TowerGroup’s Bruel. “Market-makers have gone away for very specific reasons around the economics of being a market-maker, which haven’t been good over the past five to 10 years,” he says. “If you want to add obligations to the market-maker, how do you make an economically viable business model for them to be in? To just say market-makers have these types of obligations without picking out a way to add revenue opportunities won’t work, because why would you become a market-maker if you have these obligations that mean you can’t make any money?”

Price Discovery and Audit Trails
The trade-at rule, as well as minimum-required quote duration, would reduce competition and innovation, according to Nazarali. “Minimum-quote duration allows people to enter orders and cancel them,” he says. “It’s a concern that they send orders because they want to trade, not cancel them. If cancels are 20 to 30 percent of your orders, that’s something regulators should look into.”

The non-displayed liquidity pools that would be affected by the trade-at rule do not affect price discovery to such an extent that the rule is required, according to Crosthwait. “If you were to require these dark orders to interact with small, light orders, because displayed orders tend to be 100 to 500 shares, you are requiring them to show their hand and they are not really getting any liquidity there,” she says. “So ‘dark’ really plays an important role because an institutional order of 100,000 shares cannot be displayed in a light venue. It just can’t be. To attract that liquidity to the market, you need places where it can be executed and valued as a block.”
Consolidated audit trails, which collect order, execution and cancel information, can be used to minimize costs and efforts needed for regulatory compliance in the post-Flash Crash environment, according to Adam Nunes, president of HRT Financial, a unit of Hudson River Trading. “We could minimize the cost and effort by focusing on points where there is already a key aggregation of data, and coordinating 13 end-users would be easier.”

The drawback of deploying consolidated audit trails is their “reactive” nature, says Bruel. “It’s a mechanism to work backwards and figure out what happened, as opposed to a proactive way of preventing these types of crashes,” he says. “To be able to do a consolidated audit trail and manage and monitor it in real time is a big challenge.”

Searching for Consistency
With the range of new rules and proposals, consistency should be the guiding principle, according to Bruel. “There’s not a single rule change that will work,” he says. “Each rule change needs to be made on its own merits. But there is also the cascading impact it has on other rule changes that are being considered, so all these different ideas have to be done in a coordinated manner.”

That harmonization must also apply across a range of asset classes, says Bruel. “The asset classes are so inextricably linked that if you have different rules for different asset classes—for example, if your futures and underlying cash instruments act differently—then you still have potential for dislocation, so there needs to be some consistency in how those rules are implemented,” he says. Consistent application of rules is more important than setting the amount of time for a trading halt, or the levels at which circuit breakers would trigger such a halt, according to Bruel.

Clearly, the regulators’ work is not yet done. With industry firms and venues themselves debating which proposals are reasonable and can be effective, without reducing liquidity or shrinking markets, the regulatory bodies still have a lot of viewpoints to consider. As the end of 2010 approaches, the performance of new post-May 6 circuit breakers will also have to figure into the mix.