On April 8, 2013, the new Securities and Exchange Commission (SEC) rule Limit Up-Limit Down, aka Rule 608, will go into effect in the attempt to lessen volatility in the equities market. Limit Up-Limit Down was passed on May 31, 2012 to “address extraordinary market volatility market wide.” At the time of the ruling, the Single Stock Circuit Breaker rule was in place to address market volatility, but was not consistent across the market. Limit Up-Limit Down will eventually replace the Single Stock Circuit Breaker in its entirety as it is rolled out in two phases over 2013 with the complete roll-out expected to be complete by September 2013.
To understand why this new rule has come about, one needs look no further than the events of May 6, 2010, known as the “Flash Crash.” During the Flash Crash, the market nose-dived at record rates in a very short time; within only 20 minutes, the market had dropped nearly 1000 points. Almost as fast, the market gained back nearly 600 points. This type of incident is ripe for conjecture and philanthropic thought about how to stop another Flash Crash event from taking place again. Unfortunately, the ‘why’ is generally overlooked, as seems to be the case again today, where once again firms are sent scurrying to comply with a new regulation.
As technology has advanced, the markets have relied more and more on electronic trading, which coincidentally has led to some of the most significant market events in recent times. This has put an unnecessary burden on a vast majority of firms, who, in an already fragmented market with withering profit margins, now must spend more on compliance. The costs of running a business are becoming astronomical and firms are feeling that burden.
Now it seems obvious that the Flash Crash and similar instances before and after were accelerated by high-frequency trading (HFT) and rogue algorithms. High-frequency traders profit from the smallest arbitrage opportunities available. These arbitrage opportunities cannot be spotted quickly enough by humans, so these traders rely on technology, co-location hardware, and high-tech algorithms to find, analyze, and react to the information with little to no human interaction. There’s little regulation in place for monitoring and reacting to rogue algorithms today. This all begs the question: why has the SEC chosen to develop a rule that doesn’t necessarily address the root of potential market volatility issues?
What will happen as HFT firms migrate to other asset classes and instruments where the Limit Up-Limit Down Rule does not exist?
With the advent of this new Limit Up-Limit Down rule, the onus is on broker-dealers to have a system in place that will not allow executions to occur outside the set price bands nor quote outside the price bands, and will monitor for executions that might occur during a halt after a limit state has been enacted for more than 15 seconds. Broker-dealers will also need to have access to this market data to truly understand the price band movements and how this may impact their resting limit orders.
In the end, it feels like this rule is a blanket oversight that fails to tackle the real issue around extraordinary market volatility, the rise of high frequency trading and rogue algorithms. When it comes to Limit Up-Limit Down, when will the regulators realize their limits?