Preparing for Market Disruption: Circuit Breakers and Discretionary Trading Halts

Shearman & Sterling LLP

I. Introduction

The COVID-19 outbreak and the breakdown of negotiations between oil producers have contributed to a fall in the stock market, ending the longest bull market in history and bringing about a period of volatility. As of March 23, 2020, movements in the stock market have led to four 7% declines in the S&P 500 Index this year, each triggering Level 1 cross-market circuit breakers and bringing trade to a halt across exchanges (a “trading halt”).[1] The following memo provides an overview of certain mechanisms and discretionary powers capable of pausing or stopping the trade of individual securities or general market activity.

Section 2 provides an overview of automatic halt mechanisms:

  • Section 2.1 summarizes cross-market circuit breakers that halt trading activity across exchanges when certain thresholds are met;
  • Section 2.2 discusses limit up-limit down pauses that halt the trade of a particular security that has moved beyond its specified price band; and
  • Section 2.3 presents the short sale circuit breaker/alternative uptick rule, which prevents short selling a security after its price has dropped by 10% in a given day.

Section 3 covers discretionary powers to pause or stop trading activity:

  • Section 3.1 details the power of the SEC to suspend trade of a particular security in light of suspicious activity;
  • Section 3.2 describes the power of the SEC to halt short selling across exchanges; and
  • Section 3.3 sets forth the mechanism by which the SEC can close exchanges for a period of up to 90 days.

II. Circuit Breaker Mechanisms

2.1 Cross-Market Circuit Breakers

The Securities and Exchange Commission (SEC) oversaw the creation of a coordinated cross-market trading halt system in response to the Black Monday Crash of 1987.[2] The current system, which was adopted by the SEC from a proposal by the Exchanges, FINRA, and the SEC in 2012, features three circuit breakers that automatically halt or close activity on U.S. securities exchanges in response to extreme market conditions.[3]

It is important to note that while the trading halts are cumulative, they only result in a trading halt the first time each level is reached on a given trading day. For example, if the S&P declines by 7% from the prior day’s close and a Level 1 halt takes place, the market may rise and then once again fall to a level between 7%-12.99% from the prior day’s close, which would not trigger a second trading halt. Conversely, if a 7% decline takes place triggering a Level 1 halt and the market subsequently declines to 13% from the prior day’s close, a second trading halt will take place.

Level 1 Halt:
Threshold:
A decline of 7% in the S&P 500 Index
Result:
Before 3:25 p.m. – A trading halt for 15 minutes;
At or after 3:25 p.m. – trading shall continue, unless there is a Level 3 halt.

Level 2 Halt:
Threshold:
A decline of 13% in the S&P 500 Index
Result:
Before 3:25 p.m. – 15 minutes;
At or after 3:25 p.m. – trading shall continue, unless there is a Level 3 halt.

Level 3 Halt:
Threshold:
A decline of 20% in the S&P 500 Index
Result:
At any time – trading shall halt and not resume for the rest of the day.[4]

2.2 Limit Up-Limit Down Pauses on Particular Securities

During the “Flash Crash” of May 6, 2010,[5] markets suffered a liquidity crisis and caused regulators concern about the integrity of the financial markets. In response, the SEC and FINRA worked with certain exchanges[6] to develop a system that would pause the trading of national market system securities (“NMS securities”)[7] during periods of extraordinary volatility. These efforts eventually resulted in the so-called limit up-limit down system and the Regulation NMS Plan to Address Extraordinary Market Volatility.[8]

Under the limit up-limit down system, NMS securities are divided between Tier 1 securities, which include all NMS securities included in the S&P 500 Index, the Russell 1000 Index, and certain other exchange-traded products,[9] and Tier 2 securities, which are all NMS securities other than those in Tier 1.[10] For each Tier, Securities Information Processors (“SIPs” or “Processors”) create and disseminate price bands for individual securities, and, if a security moves too far out of its price band within a period of five minutes, it enters a “limit state.”[11] If the security does not leave the limit state within 15 seconds, there is a five-minute pause on that security.[12]

2.3 The Short Sale Circuit Breaker/Alternative Uptick Rule

The SEC implemented a circuit breaker system for short sales on February 24, 2010, known as the Alternative Uptick Rule (Rule 201).[13] The circuit breaker is triggered if the price of the covered security decreases by 10% or more from its closing price on the previous day, as determined by the listing market for the covered security.[14] Once the circuit breaker is triggered, it prohibits the execution or display of a short sale in that security at a price that is less than or equal to the current national best bid. The restriction will remain in effect for the remainder of that trading day and the next trading day, which restricts short selling a stock that has dropped more than 10% in one day.[15] In practice, the measure aimed to promote market stability and preserve investor confidence by permitting long sellers to “stand in front of the line” and sell their shares before short sellers in a rapidly declining market.[16]

III. Discretionary Trading Disruptions

3.1 Discretion to Suspend Trade of a Particular Security

Pursuant to the Securities Exchange Act of 1934, as amended, (“Exchange Act”) the SEC has the authority to suspend trading of any regulated security for up to 10 business days and also has the authority to revoke a security’s registration when it has questions regarding (i) a lack of current, accurate, or adequate information about a company; (ii) the accuracy of publically available information about the company; or (iii) insider trading, market manipulation or an inability to clear and settle transactions in the stock.[17]

FINRA also has the authority to order members to halt trading and quotations in OTC Equity Securities if FINRA determines that, based on the facts and circumstances of the particular event, halting trading in the security is the appropriate mechanism to protect investors and ensure a fair and orderly marketplace.[18] It may prevent its members from trading and quoting a security for 10 business days, and it may extend that for subsequent periods of 10 days each if it deems it necessary to protect the public interest.[19]

3.2 Discretion to Halt Short Selling

The Exchange Act allows the SEC to alter, supplement, suspend or impose restrictions on matters or actions subject to regulation by the Commission, including short sales.[20] The Commission gave such an order on September 18, 2008 after concluding that short selling contributed to sudden price declines in the securities of financial institutions unrelated to true price value and issued an emergency order to halt short selling in 799 financial institutions.[21] The prohibition lasted until October 8, 2008.[22]

3.3 Discretion to Close Exchanges

The SEC and the President of the United States may also order markets to close for a period of time, and exchanges themselves may decide to close or adjust their schedules or operations.[23] Under the Exchange Act, the SEC is authorized, upon notifying the President and unless the President disapproves the decision, to “suspend all trading on any national securities exchange or otherwise, in securities other than exempted securities, for a period not exceeding 90 calendar days” if it believe that “the public interest and the protection of investors so require.”[24]

The U.S. exchanges have the authority to close their respective exchanges, although this typically would happen in coordination with the SEC.[25] While there have been numerous closures, including for anniversaries and the funerals of former U.S. presidents,[26] discretionary authority has rarely been used to close markets to address crises. Examples include the closure of exchanges following the attacks of September 11, 2001 for four days[27] and the closure of the NYSE and NASDAQ following Hurricane Sandy for two days.[28]

Whether U.S. exchanges will close at any point due to COVID-19 remains to be seen. NYSE President Stacey Cunningham recently tweeted that she firmly believes “the markets should remain open and accessible to investors” under normal trading hours.[29] U.S. Treasury Secretary Steven Mnuchin has also stated his belief that the markets should remain open.[30]

IV. Conclusion

As markets continue to react to rapidly changing current events, it will be important for broker-dealers to stay abreast of new guidance and prepare for the contingencies outlined in this memo. The Shearman & Sterling team is paying close attention to these developments, and we are happy to respond to any questions or concerns you may have.

Footnotes

[1] The cross-market circuit breaker system is discussed more fully in section 2.1.
[2] The exchanges that currently form a part of this cross-market systems are: BATS Exchange, Inc. (BATS), BATS Y-Exchange, Inc. (BYX), NASDAQ OMX BX, Inc. (BX), Chicago Board Options Exchange, Incorporated (CBOE), C2 Options Exchange, Incorporated (C2), Chicago Stock Exchange, Inc. (CHX), EDGA Exchange, Inc. (EDGA), EDGX Exchange, Inc. (EDGX), International Securities Exchange LLC (ISE), The NASDAQ Stock Market LLC (“Nasdaq”), National Stock Exchange, Inc. (NSX), New York Stock Exchange LLC (NYSE), NYSE Amex LLC (“NYSE Amex”), NYSE Arca, Inc. (“NYSE Arca”), NASDAQ OMX PHLX LLC (“Phlx”) (collectively, the “Exchanges”); See SEC Release No. 34-67090.
[3] SEC Release No. 34-67090; FINRA Rule 6121.
[4] Currently, pursuant to FINRA Rule 6121, if a Level 3 event occurs, trading in exchange listed securities is halted until the primary listing market opens the next trading day. A new FINRA proposal submitted on March 18, 2020 would allow for the opening of all NMS securities the next trading day after a Level 3 halt as on a regular trading day. See SR-FINRA-2020-009.
[5] See the SEC’s Findings Regarding the Market Events of May 6, 2010 (Sept. 30, 2010).
[6] Cboe BYX Exchange, Inc., Cboe BZX Exchange, Inc., Cboe EDGA Exchange, Inc., Cboe EDGX Exchange, Inc., Chicago Stock Exchange, Inc., Financial Industry Regulatory Authority, Inc., Investors Exchange LLC, NASDAQ BX, Inc., NASDAQ PHLX LLC, The Nasdaq Stock Market LLC, NYSE National, Inc., New York Stock Exchange LLC, NYSE American LLC, and NYSE Arca, Inc. See SEC Release No. 34-67090.
[7] Regulation NMS defines an “NMS security” as “any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options.” SEC Release No. 34-51808.
[8] SEC Release No. 34-85623; It is important to note that under FINRA Rule 6190, member firms that are trading centers in NMS securities must establish, maintain and enforce written policies and procedures that are reasonably designed to comply with the requirements of Regulation NMS Plan to Address Extraordinary Market Volatility.
[9] SEC Release No. 34-67091.
[10] Id.
[11] Id.
[12] Id.
[13] See our Client Publication, Short Sales: a New Circuit Breaker, in the Shearman & Sterling US Broker-Dealer and Market Regulation Library (March 2010).
[14] Id.
[15] SEC Release No. 34-61595.
[16] SEC Press Release 2010-26; See also our Client Publication, SEC Regulation SHO Takes Effect, Implementing a Mixed Bag of Changes to Short Sale Rules, in the Shearman & Sterling US Broker-Dealer and Market Regulation Library.
[17] SEC Investor Bulletin: Trading Suspensions.
[18] FINRA Rule 6440.
[19] Id.
[20] Securities Exchange Act of 1934.
[21] SEC Press Release 2008-211.
[22] See our Client Publication, Short-Sale Update: SEC Extends Emergency Actions Through Temporary and Final Rulemaking; Short Selling Ban Expires, in the Shearman & Sterling US Broker-Dealer and Market Regulation Library (Nov. 2008).
[23] Securities Exchange Act of 1934; see also Lananh Nguyen, NYSE to Shut Trading Floors Monday After Two Are Infected, Bloomberg News (March 18, 2020).
[24] Id.
[25] David Gura, New York Stock Exchange Closes Trading Floor, Will Operate Electronically, NBC News (March 18, 2020).
[26] David Shepardson, U.S. Markets to Close on Wednesday in Honor of George H.W. Bush, Reuters (Dec. 1, 2018).
[27] U.S. Stock Markets Close, CNN Money (Sept. 11, 2001).
[28] Dominic Rushe, New York Stock Exchange Opens to Trading After Historic Closure for Sandy, The Guardian (Oct. 31. 2012).
[29] Supra note 23.
[30] Saleha Mohsin, U.S. Plans to Keep Markets Open, Considering Shorter Hours, Bloomberg News (March 17, 2020).
 

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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