NEW YORK, Sept 2 (Reuters) - U.S. regulators and stock exchanges are re-examining rules designed to ensure orderly trading in equities after investors fell afoul of them during a near-unprecedented bout of volatility at the beginning of last week, exchange officials said.
The measures, which include pausing trade in individual stocks if their prices move violently in a short time, were introduced after the 2010 flash crash when around $1 trillion in paper value was temporarily wiped from U.S. stock markets within minutes.
But some investors have said that the rules failed their first big test on Aug. 24, when panic over the health of the Chinese economy triggered a record intraday drop in the Dow Jones Industrial Average.
During the mayhem, more than 1,250 trading halts were triggered in 455 stocks and exchange-traded funds (ETFs), which are used by ordinary investors to gain exposure to a basket of securities or an entire index.
The sporadic and rapid-fire halts led to confusion among some investors as to what was trading and questions whether they got prices worse than they should have.
“We had some really errant prints out there that stood that shouldn’t have stood,” said Reggie Browne, senior managing director at Cantor Fitzgerald, who is known as the godfather of ETFs.
The U.S. Securities and Exchange Commission is now pouring through the trading data from Aug. 24 to get a better idea of what might be done to dampen the volatility in ETFs, many of which saw their prices diverge widely from the stocks they were tracking, said a person familiar with the regulator’s thinking.
The SEC has been looking to adjust the rules for some time, but the recent events have added a sense of urgency, said the person, who did not have permission to be quoted in the media.
While the rules prevented the massive canceled trades that followed the flash crash, the widespread halts may have slowed down the markets’ recovery, prompting calls for SEC and the exchanges to redesign them.
“It exposed the sledgehammer nature of the tools they gave markets,” said Dave Nadig, director of ETF research at FactSet.
The explosion in ETFs since the flash crash, now numbering 1,614 versus 950 five years ago, is another factor in the SEC’s decision to take another look at the rules. The amount of investor dollars in ETFs has more than doubled to $2.1 trillion from $826 billion, according to Lipper.
One post-2010 rule, called Limit Up Limit Down, prevents stocks from trading outside of a specific range based on recent prices, pausing the stocks when trading occurs outside of its limits. The rule was applied in 2013 to ETFs, which are securities that track indexes, commodities, bonds or baskets of securities, and trade like stocks.
One of the issues from last Monday was that when the market opened, many stocks were halted or their openings were delayed as the market tanked, making it difficult to properly price some ETFs that had the halted stocks as constituents.
The SEC has long been aware that Limit Up Limit Down affects ETFs differently than single stocks and has asked the exchanges to suggest adjustments to the rule to help smooth out its effects by October, said Steve Crutchfield, head of exchange traded products at the New York Stock Exchange.
“Everything is on the table,” he said in terms of the potential adjustments to the parameters of the program, which would have to be approved by the SEC.
The SEC is also looking at the long-standing differences between how the NYSE, owned by Intercontinental Exchange Inc , and the Nasdaq open the stocks listed on their exchanges during times of market stress, the source said.
NYSE, unlike other exchanges, which are nearly fully automated, uses people on its trading floor to open its stocks, a process it says gives it greater stability because the traders can intervene in ways that algorithms cannot.
But rivals say that using humans rather than computers caused undue delays in opening some stocks and ETFs after they were halted last Monday, intensifying ETF pricing issues.
“At the open, most markets except for the NYSE opened at 9:30, and if you’re trading an S&P ETF and 50 percent of the S&P is not open, you have some pricing challenges on your hands,” said Chris Concannon, head of exchange operator BATS Global Markets.
In the fallout of the pricing problems, ETF provider The Vanguard Group said it was going over all of the trades on Monday to see if investors should have gotten different prices than they did. However there is no recourse for these investors because the rule for erroneous trades require investors to notify the exchanges within 30 minutes if they got a bad price.
The “clearly erroneous” trades rule is a standard definition of trades that exchanges will cancel if executed, based on how far away from the public stock price they are, and it too was updated after the flash crash.
Some, like Cantor’s Browne, thing those rules also need tweaking, but the SEC believes that rule could become redundant if the exchanges get the Limit Up Limit Down rules right. (Reporting by John McCrank; editing by Carmel Crimmins and Cynthia Osterman)