How the SEC's New Circuit Breakers for Stocks Would Work

Investors left dizzy and stunned after the Dow's whiplash ride of a near-1,000-point drop earlier this month may take comfort in new circuit breaker rules the Securities and Exchange Commission released Tuesday.

Under the proposal, the New York Stock Exchange, Nasdaq, BATS Global Markets, Direct Edge and other exchanges would temporarily halt trading -- using software safeguards known as circuit breakers -- in individual stocks in the S&P 500 Index when a stock price swings 10% up or down in the span of five minutes. These circuit breakers would be applied between 9:45 a.m. to 3:35 p.m. (ET) during the trading day.

The SEC staff is also working to get the exchanges to consider lowering the threshold of when to implement marketwide circuit breakers (as opposed to those on specific stocks) beyond the current triggers set for 10%, 20% and 30% dropsin the Dow Jones Industrial Average.

The SEC plans to take public comments on the new proposal for 10 days after it's published in the Federal Register (perhaps this Friday or next Monday). Once the commission approves the new rules, they'll take effect on a pilot basis and become permanent on Dec. 10.

Similar to the NYSE's Current System

Since you won't find them slapped against the wall in the basement of the 13 SEC-registered stock exchanges, here's a glimpse of how the new circuit breakers work.

They're built into computer systems that are part of each exchange's own proprietary trading platform, such as Nasdaq's INET or the NYSE's DisplayBook, or DBK. These trading platforms are interconnected to a consolidated data feed, a high-speed, real-time electronic system that displays the latest price and volume for each exchange-listed stock.

The proposal calls for a dramatic change to the way the exchanges treat individual stocks, with the exception of the NYSE, which already uses "mini-circuit breakers" for individual stocks called liquidity refreshment points (LRPs). In the current NYSE system,the exchange moves from an automated trading platform to a manual "auction" for stocks that move approximately 2% to 3% in either direction at any point in the trading day from its previous closing price, with no restrictions on how long that stock has to maintain that price before the LRPs take affect.

The 2% to 3% trigger is actually a reflection of an LRP bracket that's created around the stock price and that moves with the stock as it trades during the day. For example, a $25 stock would have an LRP bracket of 50 cents. So, if the stock moves beyond $24.50 on the downside or $25.50 on the upside, NYSE trading in it would move from the automated system to a market specialist for 5 to 10 seconds, or until the specialist executes a trade -- whichever comes first. The manual auction relies on people serving as market makers to bring stability and liquidity to an individual stock.

Aligning the Rules

Under the SEC proposal, however, any S&P 500 stock that experiences a 10% swing within five minutes would receive a timeout, and trading in that stock would pause for five minutes across all domestic equity markets.

The SEC says it believes the mega-disruption of May 6 was due in part to disparate trading rules among the exchanges. For example, while the NYSE slowed down trades during the day by moving to an auction format, electronic trading was still moving full-bore.

And that's the key disconnect the SEC is trying to fix. "It's either on or it's off for electronic trading," says a spokesman for Jersey City, N.J.-based Direct Edge. "The NYSE has a floor for brokers to do an open outcry. We don't have that kind of slow mode."

And like any piece of technology, these electronic trading platforms are also subject to glitches and bugs. But the domestic exchanges have fared better than those in the U.K., where the London Stock Exchange is the dominant game in town.

"Here, there's less of a monopoly,"says the Direct Edge spokesman, "and because we're all interconnected, when we have periodic glitches and an exchange shuts down, the trades can be routed to other exchanges seamlessly." At least, until something goes seriously wrong, as it did on May 6.

Broader Circuit Breakers Remain Unchanged

The SEC's new stock-specific circuit breaker proposal doesn't change the existing marketwide circuit breaker system, which has three trigger points based on the Dow (see table for details). The other major exchanges, such asNasdaq, NYSE, BATS, Direct Edge, ISE and CBOE, follow this pattern as well.

Each of the exchanges are alerted when the trigger level has been reached by the same data feed that spits out stock prices and volume, says Ray Pellecchia, an NYSE spokesman. With that information, each of the exchanges' automated trading platforms comes to a halt.

Although the new proposal doesn't affect this marketwide circuit breaker, the SEC staff may be considering lowering the bar to somewhere south of a 10% index move.

Editor's note: This story has been updated to reflect the correct the location of Direct Edge.