A few days after the May 6th Flash Crash last year we received a phone call from a large HFT firm.  They took issue with a few things that we had written and wanted to set the record straight.  The HFT also wanted us to get on board with a market reform that they thought would help prevent another flash crash – limit up/limit down circuit breakers.  Of course, being the skeptical types, we immediately became suspicious about the limit up/limit down breakers.   Since that phone call, over a year ago, we have heard almost every major player in the exchange and broker community give the thumbs up to this type of circuit breaker (more suspicion raised).  Status quo market participants who have been enjoying fat profits for the past few years seem to think that this type of circuit breaker would be the least damaging to their business models.  On May 25th, 2011, the SEC published a proposal which was submitted by the major exchanges (even more suspicion raised) to adopt a limit up/limit down style circuit breaker. Read SEC proposal here

At this point, it appeared the fix was in and it would only be a matter of time before this proposal was approved.  But a funny thing happened during the comment period.   Two major industry organizations, SIFMA and the STA, submitted comment letters which questioned major portions of the proposal that the exchanges submitted.

1) Amongst other issues, the STA was concerned about the role of the SIP (the “Securities Industry Processor” and whether it “will be able to calculate and disseminate the limit up and limit down price bands in an accurate and timely manner.” Read STA comment letter here They want the SIP’s to prove they can handle the new limit up/down curbs. They are concerned that if the SIP falls behind then  “when latencies or inefficiencies have existed in the past, certain market participants have been able to exploit them to their own benefit, which can result in a loss of investor confidence.”  In prefacing this concern, the STA pointed to “liquidity arbitrage” concerns.  The STA stated:

“In the case of “liquidity arbitrage”, the market weakness is in the latency differences between the market data disseminated by the various SIPs (CQS and UQDF) versus direct data feeds…It is reasonable to understand why market participants, who were historically disadvantaged for using the market data obtained via the SIP over firms who used direct feeds, may be skeptical that the Processor will be able to fulfill their new responsibilities as required in the Plan.”

2) SIFMA seemed concerned about the unintended consequences of new regulations (glad to see they are finally catching on).  They warned:

“The Proposed Plan is complex, and interpretive guidance is necessary to ensure that the proposals will not inadvertently reduce market liquidity or otherwise introduce unintended and adverse consequences into the market.” Read SIFMA comment letter here

Other commenters complained that the new rules would be adding just another layer of complexity to a very complex equity market structure.   We think Steve Wunsch said it best in his comment letter Read Wunsch comment letter here :

“The more complex the Commission makes the market, the more likely it is that surprises like the flash crash will occur. The remedies that have been enacted or are contemplated to address extraordinary volatility in the wake of the flash crash, including the limit up ‐ limit down plan, have ratcheted up complexity by an order of magnitude from anything we have seen before.”

It looks like there is trouble in paradise and the holy grail of circuit breakers may have some tweaks to be made on them before getting approved.  But fear not, your friendly neighborhood exchange has you protected with some  changes to the existing single stock circuit breakers.  More on that tomorrow