SEC Proposals Will Likely Alleviate Future Flash Crashes, But Come With a Cost

In the aftermath of the so-called 'Flash Crash' of May 6th, the SEC has announced that it will propose new circuit breakers in an attempt to alleviate pressures on the system when high periods of volatility threaten investors and the overall market. Circuit breakers, or trading curbs, are a means of temporarily halting trading during dramatic sell-offs to allow market participants time to respond. According to CNBC, quoting 'multiple sources,' 'The SEC and exchanges are considering circuit breakers that would halt trading in a company's stock if the stock fell more than 10 percent in five minutes...' Though circuit breakers already exist, they didn't come into play on the 6th. Additionally, while existing curbs currently kick in when entire indices, such as the Dow, fall by certain amounts, the new proposals would impact trading in individual securities, a key change.

Putting aside for the moment any arguments over the merits of government regulation of trading curbs, the proposed rules would seem to alleviate some of the pressures which exacerbated selling on the 6th. Though regulators and pundits alike seem to be at odds over what all of the factors were, Blawgconomics has good information that one such pressure point was the mass execution of stop loss orders (see #2 in this very well-written Seeking Alpha piece for explanation). Without digging too far into the links, the problem can be summarized as follows: investors often place orders for stocks to sell automatically when they reach a certain price to protect against downside losses. However, if a stock is really crashing, the next bid, or selling price, after the triggering price may be significantly lower than the seller intended...sometimes even pennies on the dollar. On the 6th, the execution of stop loss orders led to more stop loss orders being triggered, a vicious circle which apparently led to the temporary shutdown of certain brokers' trading platforms.

Curbs make sense in certain circumstances. After the Flash Crash, it was hypothesized that one of the triggering events was large, incorrectly entered orders. This happens, and it makes the already-existing curbs on trading when indices plummet sensible. After all, there are systemic risks in such a situation, and it is very unlikely that an entire market would plummet with no plausible explanation, even a rumor, that investors could adjust to. However the proposed single-stock curbs are a different creature and may have a downside. Often in individual securities a dramatic drop reflects new information such as poor earnings or a CEO change, or even a rumor, such as an M&A transaction, that the markets are adjusting to. This is a healthy function of the market as all information should be utilized in determining the price of a stock, and therefore a company. However, due to the restrictions on trading the SEC intends to put into place, it seems that these new curbs would have a detrimental effect on the ability of the market to serve this function.

Perhaps this would be the appropriate point of entre into the discussion of government intervention that was avoided above...but we can save that for another day. For now, it is probably enough to note that the proposed curbs will probably do what they are intended to do, albeit at a potentially significant cost.

UPDATE: Reuters has some different perspectives on these proposed curbs, along with some solid quotes from market participants.