New Stock Regulations: Market Killer or Savior?

By Steve Ehrlich, Lightspeed Financial CEO

New Stock Regulations: Market Killer or Savior?

By Steve Ehrlich

Lightspeed Financial CEO

June 3rd, 2010 – The financial markets and regulatory bodies have been engaged in a no-holds-barred cage fight since the inception of the marketplace. Regulators have sought to control the free market for the benefit of all participants and society in general. While the market itself, along with most free market advocates, has valiantly battled any and all attempts at regulation. Provided the diverse nature, goals and methods of stock market participants, clearly some regulation is needed to even the playing field and insure fairness across the board. Just how much is too much is the burning question.

Due to recent extreme stock market volatility, the spotlight is back on stock regulations. The primary points of concern involve the so-called “circuit breakers” and market participatory mandates. I'd like to shed light onto these two hot market topics so that you can have a deeper understanding of the potential changes taking place.

Circuit Breakers

Circuit breakers, or trading curbs, were first introduced in 1987, after the major stock market crash in recent memory. Regulators were pressured to institute measures that would prevent a repeat of the meltdown that occurred on that fateful “Black Monday” in October of 1987. Their solution was to create a tiered system of trading curbs that would trigger should the Dow Jones Industrial Average fall 10, 20 or 30% from the previous month's average price.

For example, a 10% drop would result in an hour trading halt if the drop occurred before 2:00 p.m. EST, one half hour halt between 2:00 and 2:30 p.m. and no halt should the 10% drop occur after 2:30 p.m. A 20% drop would lead to a 2 hour trading halt before 2:00 p.m. and a complete stop to trading should the drop occur after 2:00 p.m. An extreme breakdown of 30% would result in the stock market being closed for the day regardless of when it occurred.

These circuit breakers are well-intentioned; however, the advent of the modern multiple exchange and connected marketplace demands a reassessment of the old rules. The “flash crash” that occurred on May 6 is a prime example of why such rules need reform. Mary Schapiro, the chairman of the SEC, stated that she believes that it is imperative that all 50 US exchanges reach a consensus on circuit breakers to prevent another “flash crash” from throwing the markets into disarray.

The new proposed rules would halt trading in any S&P 500 stock that has moved 10% or more in a five-minute period. This rule applies to both moves up and down. The halt would be for 5 minutes immediately after the 10% move within the preceding 5 minutes. The SEC believes this pause would provide the marketplace time to attract new interest, establish a reasonable market price and resume trading.

Using wisdom and foresight seldom seen in a governmental agency, the SEC proposed that these new regulations be subject to a pilot program until December 10, 2010. During this time, the parameters will be tweaked to discover the optimal settings. These regulations are expected to spread to all financial markets, including futures, within the next several years.

While the SEC should be applauded for its use of a pilot program, other factors must be taken into consideration prior to implementation of the new rules. The percentage move that will trigger the halt should be keyed to different categories of stocks. For example, for optimal results, the SEC needs to consider the liquidity, average daily volume, price and the stock's index to properly set the percentage move that will trigger the halt. Our fingers are crossed that the SEC will continue to use its pro-market-based wisdom and consider these factors.

Market Participatory Mandates

Perhaps a more onerous regulatory suggestion is that of market participatory guidelines. In other words, the government will tell you when you can and cannot trade. The primary idea is to prevent HFT firms from “stepping away” from trading during extreme events. Just like the market-maker has to provide a bid for your trade, these HFT firms may soon have to continue to provide liquidity regardless of market conditions and self-induced damage.

These ideas stand 180 degrees opposite of where markets have been heading for the last 10 years. While fewer regulations in this regard have led to strong growth in the marketplace, this type of control is being discussed once again. The guidelines may be well-intentioned and designed to prevent another May 6-type volatility event. However, regulators need to be cautious as this may open a Pandora's box of additional market friction. Causing many unintended consequences of any new market participatory mandates.

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Posted on June 3, 2010