New SEC Stock Trading Rules May Do More Harm Than Good

A number of stock market participants believe the Security and Exchange Commission's decision to leave exchange-traded funds (ETFs) out of proposed new circuit breaker rules designed to avoid a repetition of the May 6 stock market "flash crash" may do more harm than good.

"It's just a Band-aid, it really doesn't address the issue," says Ted Weisberg, president and floor trader for Seaport Securities in New York.

SEC Chairman Mary Schapiro told the House Banking Subcommittee on Securities, Insurance and Investment on Thursday that the new circuit breaker rules would be implemented for a pilot period that would last until Dec. 10. She added the SEC's enforcement division was looking at a wide variety of actions that took place on May 6, and "if we identify any activity that violates the securities laws, we will take appropriate action."

Explaining the May 6 "Flash Crash"

The new SEC rules are an attempt to address the still-unexplained gyrations in the stock market on May 6, when the Dow Jones Industrial Average plummeted 1,000 points in the space of a few minutes and then rebounded sharply. Among the reasons advanced for the "flash crash" was heavy selling of futures contracts linked to the Standard & Poor's 500 stock index, the withdrawal of a number of traders from the market during the height of the crash, and the different methods used to trade equities by the different stock markets, such as the New York Stock Exchange (NYSE) and the Nasdaq.

Under the new rules, a five-minute trading pause would be triggered when a stock moved more than 10% up or down in the preceding five minutes. But the rules apply only to stocks in the S&P 500, and therefore don't include ETFs, which are traded like individual shares but represent a basket of stocks, similar to stock indexes. Many index ETFs contain S&P 500 stocks, so they would continue to be traded while the underlying stocks were frozen.

"I think probably the worse thing to do is do it half-assed, to do it for some stocks and not for ETFs," says Michael Pento, senior market strategist at Delta Global Advisers in Boston. "The best thing to do is just let stocks trade and let the market be open."

ETFs Most Affected by "Flash Crash"

An investigation into the "flash crash" by the SEC and the Commodity Futures Trading Commission found that nearly 70% of the trades that were cancelled by the exchanges, because they swung more than 60% from the last trade at the beginning of the crash, were ETF shares. "ETFs as a class were affected more than any other category of securities," the investigation concluded.

Schapiro told the committee Thursday that ETFs may be included in the circuit breaker rules after the six-month pilot period expires. But that doesn't explain how the trial period can possibly work without including them.

Duncan Niederauer, CEO of the NYSE Euronext (NYX), says that all U.S. stocks will have to be protected by circuit breaker rules. "They need to be applied to all the markets, not just some of the markets," Niederauer said in Shanghai.

Weisberg of Seaport Securities says the rules fall short because the S&P 500 is only a small subset of the approximately 9,000 publicly traded stocks in the U.S. "I think whatever the rules, they need to go across all markets and should be expanded beyond 500 stocks," Weisberg says. "It should be the market in general, including ETFs, which are publicly traded stocks and are very, very popular."

More Traders Would Stabilize the System

Weisberg has two proposals to fix the system that caused the May 6 crash. He says the market should abandon the decimal system, which the SEC ordered adopted in April 2001. The old system, using 1/16 fractions, produced a 5-cent increment that he said allowed specialist dealers to make a profit on trades.

Having more dealers trading would help stabilize the system, unlike the current atmosphere where "everyone is gaming the system," Weisberg says.

Weisberg also calls for reintroduction of the so-called uptick rule, which was repealed in July 2007. Under the uptick rule, so-called short sales -- when an investor tries to make money by selling borrowed shares, then buying them back at a lower price and pocketing the difference -- could only take place if the last sale of a stock happened at a higher price than the preceding sale. The rule was repealed because the proliferation of stock market trading venues made it almost impossible to know what the last traded price is.

High-Frequency Traders Are First Priority

Weisberg thinks current government regulators aren't interested in the public interest or average investors, but that their first priority is now high-frequency traders -- who place thousands of trades per second -- and other professional trading organizations. "I think the average investor, and I would include mutual finds, is at an extreme disadvantage because the playing field is clearly not level," he says.

Pento of Delta Global Advisors says that by excluding ETFs, the SEC created an unworkable system. "You halt trading in XYZ shares, but XYZ continues to be traded in the ETFs, so that's going to be a little nebulous for investors to understand how that's going to work."

He says more markets should adopt the NASDAQ OMX (NDAQ) system of having market makers -- the brokers who buy and sell stocks electronically -- provide the liquidity in shares and two-sided quotes. "There are more buffers in there, with market makers risking their own capital, giving support when a stock is falling and giving resistance when it is rising, so you have a much more stable market," he says.