Goodbye to volatility, hello to arbitrage!

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The US Securities and Exchange Commission approved two proposals those are designed to curb volatility in individual securities and the broader US stock market on 31 May, 2012. The national securities exchanges and the Financial Industry Regulatory Authority will implement the approved proposals by 4 February, 2013, for a one-year pilot period, during which the assessment regarding any additional modifications will be made. So, what are the chosen market control measures and how will be the effect estimated during the pilot period?

One of the approved initiatives establishes a “limit up-limit down” mechanism that prevents trades in individual stocks with a specified price band, which would be set at a percentage level above and below the average price of the security over the immediately preceding five-minute period. According to the news released by the US SEC on 1 June, 2012, for more liquid securities — those in the S&P 500 Index, Russell 1000 Index, and certain exchange-traded products — the level will be 5 percent, and for other listed securities the level will be 10 percent. The percentages will be doubled during the opening and closing periods and broader price bands will apply to securities priced $3 per share or less. This new mechanism will replace the existing single-stock circuit breakers that the Commission approved on a pilot basis after the market events of May 6, 2010.

The other initiative updates existing market-wide circuit breakers those halt trading in all exchange-listed securities throughout the U.S. markets. The existing market-wide circuit breakers were adopted in October 1988 and have been triggered only once, in 1997. The new requirements according to the US SEC involve a reduction of the market decline percentage thresholds needed to trigger a circuit breaker to 7, 13, and 20 percent from the prior day’s closing price, rather than declines of 10, 20, or 30 percent; a shortened duration of trading halts that do not close the market for the day to 15 minutes, from 30, 60, or 120 minutes; a simplified structure of the circuit breakers so that there are only two relevant trigger time periods instead of six, those that occur before 3:25 p.m. and those that occur on or after 3:25 p.m.; a usage of broader S&P 500 Index, rather than the Dow Jones Industrial Average, as the pricing reference to measure a market decline and a requirement to recalculate the trigger thresholds daily rather than quarterly.

However, I wonder how the authorities will measure the effect of attempts to protect domestic markets from excessive volatility. Imposed trading halts those close domestic markets creates an arbitrage opportunities for the companies’ securities traded in other opened stock exchanges. So, these efforts to control volatility may deepen market distortions and could be welcomed as risk free opportunities.