
[Federal Register: September 16, 2010 (Volume 75, Number 179)]
[Notices]               
[Page 56608-56613]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr16se10-104]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-62883; File No. SR-FINRA-2010-033]

 
Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Order Approving Proposed Rule Change Relating To 
Expanding the Pilot Rule for Trading Pauses Due to Extraordinary Market 
Volatility to the Russell 1000[supreg] Index and Specified Exchange 
Traded Products

September 10, 2010.

I. Introduction

    On June 30, 2010, the Financial Industry Regulatory Authority, Inc. 
(``FINRA'') filed with the Securities and Exchange Commission 
(``Commission''), pursuant to Section 19(b)(1) \1\ of the Securities 
Exchange Act of 1934 (``Act''),\2\ and Rule 19b-4 thereunder,\3\ a 
proposed rule change to amend its rules to expand the trading pause 
pilot in individual stocks comprising the S&P 500[supreg] Index (``S&P 
500'') when the price moves ten percent or more in the preceding five 
minute period to securities included in the Russell 1000[supreg] Index 
(``Russell 1000'') and specified Exchange Traded Products 
(``ETPs'').\4\ The proposed rule change was published for comment in 
the Federal Register on July 7, 2010.\5\ The Commission received 19 
comments on the proposal and on broader issues relating to the 
effectiveness of the circuit breaker pilot program to date.\6\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 15 U.S.C. 78a.
    \3\ 17 CFR 240.19b-4.
    \4\ For purposes of Phase II, ETPs consist of exchange-traded 
funds (including widely traded broad-based funds like SPY), 
exchange-traded vehicles (which track the performance of an asset or 
index, providing investors with exposure to futures contracts, 
currencies and commodities without actually trading futures or 
taking physical delivery of the asset), and exchange-traded notes.
    \5\ See Securities Exchange Act Release No. 62416 (June 30, 
2010), 75 FR 39069 (July 7, 2010) (SR-FINRA-2010-033).
    Also on June 30, 2010, each of BATS Exchange, Inc. (``BATS''), 
NASDAQ OMX BX, Inc. (``BX''), Chicago Board Options Exchange, 
Incorporated (``CBOE''), Chicago Stock Exchange, Inc. (``CHX''), 
EDGA Exchange, Inc (``EDGA''), EDGX Exchange, Inc. (``EDGX''), 
International Securities Exchange LLC (``ISE''), The NASDAQ Stock 
Market LLC (``NASDAQ''), New York Stock Exchange LLC (``NYSE''), 
NYSE Amex LLC (``NYSE Amex''), NYSE Arca, Inc. (``NYSE Arca''), and 
National Stock Exchange, Inc. (``NSX'') securities exchanges filed 
proposed rule changes to expand the pilot program. See Securities 
Exchange Act Release Nos. 62407 (June 30, 2010), 75 FR 39060 (July 
7, 2010); 62415 (June 30, 2010), 75 FR 39086 (July 7, 2010); 62409 
(June 30, 2010), 75 FR 39078 (July 7, 2010); 62408 (June 30, 2010), 
75 FR 39065 (July 7, 2010); 62417 (June 30, 2010), 75 FR 39074 (July 
7, 2010); 62418 (June 30, 2010), 75 FR 39084 (July 7, 2010); 62419 
(June 30, 2010), 75 FR 39070 (July 7, 2010); 62414 (June 30, 2010), 
75 FR 39081 (July 7, 2010); 62411 (June 30, 2010), 75 FR 39067 (July 
7, 2010); 62412 (June 30, 2010), 75 FR 39073 (July 7, 2010); 62413 
(June 30, 2010), 75 FR 39076 (July 7, 2010); and 62410 (June 30, 
2010), 75 FR 39063 (July 7, 2010). Those rule changes were approved 
today. See Securities Exchange Act Release No. 62884 (September 10, 
2010).
    In this order, the term ``Exchanges'' refers collectively to all 
of the exchanges. The term ``Listing Markets'' refers collectively 
to NYSE, NYSE Amex, NYSE Arca, and NASDAQ. The term ``Nonlisting 
Markets'' refers collectively to the remaining national securities 
exchanges. The term ``SROs'' refers to the Exchanges and the 
Financial Industry Regulatory Authority (``FINRA'').
    \6\ The Commission considered letters received as of August 25 
discussing the concept of the effectiveness of the individual stock 
circuit breaker pilot to date as well as formal letters citing the 
rule filings. See Letter from Paul Schott Stevens, President & CEO, 
Investment Company Institute to Chairman Schapiro, Commission, dated 
June 22, 2010 (``ICI Letter''); Letter from Craig S. Donohue, CEO, 
CME Group, Inc. to Chairman Schapiro, Commission, dated June 23, 
2010 (``CME Letter''); Letter from Ann L. Vlcek, Managing Director 
and Associate General Counsel, Securities Industry and Financial 
Markets Association to Elizabeth M. Murphy, Secretary, Commission, 
dated June 25, 2010 (``SIFMA Letter''); Letter from Peter Skopp, 
President, Molinete Trading Inc. to Elizabeth M. Murphy, Secretary, 
Commission, dated July 8, 2010 (``Molinete Letter''); Letter from 
Sal L. Arnuk, Co-Head, and Joseph Saluzzi, Co-Head, Themis Trading 
to Elizabeth M. Murphy, Secretary, Commission, dated July 8, 2010 
(``Themis Letter''); Letter from Peter A. Ianello, Partner, CSS, LLC 
to Elizabeth M. Murphy, Secretary, Commission, dated July 15, 2010 
(``CSS Letter''); Letter from Julie S. Sweet, General Counsel, 
Secretary, Chief Compliance Officer, Accenture plc to Elizabeth M. 
Murphy, Secretary, Commission, dated July 15, 2010 (``Accenture 
Letter''); Letter from Patrick J. Healy, CEO, Issuer Advisory Group, 
LLC, Washington, District of Columbia to Elizabeth M. Murphy, 
Secretary, Commission, dated July 18, 2010 (``Issuer Advisory Group 
Letter''); Letter from Alexander M. Cutler, Chair, Business 
Roundtable Corporate Leadership Initiative, Business Roundtable, to 
Elizabeth M. Murphy, Secretary, Commission, dated July 19, 2010 
(``Business Roundtable Letter''); Letter from Geva Patz, Android 
Alpha Fund to Elizabeth M. Murphy, Secretary, Commission, dated July 
19, 2010 (``Android Alpha Fund Letter''); Letter from David C. 
Cushing, Director of Global Equity Trading, Wellington Management 
Company, LLP to Elizabeth M. Murphy, Secretary, Commission, dated 
July 19, 2010 (``Wellington Letter''); Letter from Karrie McMillan, 
General Counsel, Investment Company Institute to Elizabeth M. 
Murphy, Secretary, Commission, dated July 19, 2010 (``ICI 2 
Letter''); Letter from Ira P. Shapiro, Managing Director, BlackRock, 
Inc., San Francisco, California to Elizabeth M. Murphy, Secretary, 
Commission, dated July 19, 2010 (``BlackRock Letter''); Letter from 
Tom Quaadman, Vice President, Center for Capital Markets 
Competitiveness, Washington, District of Columbia to Elizabeth M. 
Murphy, Secretary, Commission, dated July 19, 2010 (``CCMC 
Letter''); Letter from James J. Angel, Associate Professor of 
Finance, Georgetown University, dated June 19, 2010 [sic] (``Angel 
Letter''); Letter from John A. McCarthy, General Counsel, GETCO to 
Elizabeth M. Murphy, Secretary, Commission, dated July 20, 2010 
(``GETCO Letter''); Letter from Jose Marques, Managing Director, 
Deutsche Bank Securities Inc. to Elizabeth M. Murphy, Secretary, 
Commission, dated July 21, 2010 (``Deutsche Bank Letter''); Letter 
from Paul Schott Stevens, President & CEO, Investment Company 
Institute to Chairman Schapiro, Commission, dated July 27, 2010 
(``ICI 3 Letter''); Letter from Craig S. Donohue, Chief Executive 
Officer, CME Group to Elizabeth M. Murphy, Secretary, Commission, 
dated July 30, 2010 (CME 2 Letter'').
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    The Commission finds that the proposals are consistent with Section 
15A(b)(6) of the Act,\7\ as it believes that expanding the uniform, 
market-wide trading pauses will serve to prevent potentially 
destabilizing price volatility and will thereby help promote the goals 
of investor protection and just and equitable principles of trade. This 
order approves the proposed rule change.
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    \7\ 15 U.S.C. 78o-3(b)(6). That section, among other things, 
requires that FINRA rules must be designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade and in general, to protect investors and the 
public interest.
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II. Description of the Proposals

    On May 6, 2010, the U.S. equity markets experienced a severe 
disruption.\8\ Among other things, the prices of a large number of 
individual securities suddenly declined by significant amounts in a 
very short time

[[Page 56609]]

period, before suddenly reversing to prices consistent with their pre-
decline levels. This severe price volatility led to a large number of 
trades being executed at temporarily depressed prices, including many 
that were more than 60% away from pre-decline prices and were broken by 
the national securities exchanges. The Commission is concerned that 
events such as those that occurred on May 6 can seriously undermine the 
integrity of the U.S. securities markets. Accordingly, it is working on 
a variety of fronts to assess the causes and contributing factors of 
the May 6 market disruption and to fashion policy responses that will 
help prevent a recurrence.
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    \8\ The events of May 6 are described more fully in the report 
of the staffs of the Commodity Futures Trading Commission (``CFTC'') 
and the Commission, titled Report of the CFTC and SEC to the Joint 
Advisory Committee on Emerging Regulatory Issues, ``Preliminary 
Findings Regarding the Market Events of May 6, 2010,'' dated May 18, 
2010 (``Joint Report'').
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    The Commission also recognizes the importance of moving quickly to 
implement appropriate steps that could help limit potential harm from 
extreme price volatility. In this regard, it is pleased that the SROs 
began consulting soon after May 6 in an effort to develop consistent 
circuit breaker rules that could be implemented on an expedited basis. 
The SROs were able to reach agreement on a consistent approach and, on 
May 18 and 19, 2010, all of the SROs filed proposed rule changes with 
the Commission.
    On June 10, 2010, the Commission granted accelerated approval, for 
a pilot period to end December 10, 2010, for a proposed rule change by 
FINRA to pause trading during periods of extraordinary market 
volatility in S&P 500 stocks (the ``Phase I Circuit Breaker 
Pilot'').\9\ That rule requires FINRA, once a Listing Market issues a 
trading pause, to halt trading otherwise than on an exchange in that 
security until trading has resumed on the primary listing market.\10\ 
The Listing Markets are required to notify the other exchanges, market 
participants and FINRA of the imposition of a trading pause by 
immediately disseminating a special indicator over the consolidated 
tape. Under the rules, once the Listing Market issues a trading pause, 
FINRA is required to pause trading in the security otherwise than on an 
exchange.
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    \9\ See Securities Exchange Act Release No. 62251 (June 10, 
2010), 75 FR 34183 (June 16, 2010) (SR-FINRA-2010-025) (``Phase I 
Approval Order'').
    \10\ The rules of the Exchanges require the Listing Markets to 
issue five-minute trading pauses for individual securities for which 
they are the primary Listing Market if the transaction price of the 
security moves ten percent or more from a price in the preceding 
five-minute period.
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    At the end of the five-minute pause, the Listing Market reopens 
trading in the security in accordance with its procedures for doing so. 
Trading resumes on other exchanges and in the over-the-counter (OTC) 
market once trading has resumed on the Listing Market. In the event of 
a significant imbalance on the Listing Market at the end of the trading 
pause, the Listing Market may delay reopening. If the Listing Market 
has not reopened within ten minutes from the initiation of the trading 
pause, however, FINRA will halt trading otherwise than on an exchange 
in that security until trading has resumed on the primary Listing 
Market. FINRA may permit the resumption of trading if trading has 
commenced on at least one other national securities exchange.\11\
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    \11\ For more details on the operation of FINRA's rule, see 
Securities Exchange Act Release No. 62251.
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    Several commenters on the proposal for the Phase I Circuit Breaker 
Pilot expressed the view that the circuit breaker pilot should be 
expanded beyond S&P 500 stocks, particularly to exchange traded funds 
(``ETFs'') and the securities of other companies that were most 
severely affected by the market disruption on May 6, 2010.\12\ In the 
approval order for the Phase I Circuit Breaker Pilot, the Commission 
agreed that consideration should be given by the exchanges and FINRA to 
whether the circuit breakers should be expanded to cover additional 
securities, but did not believe that there was a reason to delay 
implementation of the Phase I Circuit Breaker Pilot as a reasonable 
first step to address potential market volatility.
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    \12\ See, e.g., Letter from Jeffrey W. Rubin, American Bar 
Association Business Law Section to Elizabeth M. Murphy, Secretary, 
Commission, dated June 3, 2010; Letter from Julie Sweet, Accenture 
plc to Elizabeth M. Murphy, Secretary, Commission, dated June 3, 
2010; and Letter from Karrie McMillan, Investment Company Institute 
to Elizabeth M. Murphy, Secretary, Commission, dated June 3, 2010 
(expressing particular concern that if circuit breakers exist for 
individual securities contained in ETFs' baskets, but not for the 
ETFs themselves, ETFs could again suffer disproportionately during a 
market event such as that of May 6).
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    Under the current proposal, FINRA proposes to add securities 
included in the Russell 1000, as well as specified ETPs, to the pilot 
(the ``Phase II Circuit Breaker Pilot'') shortly after the Commission 
approves the proposed rule changes. FINRA believes that adding these 
securities to the pilot would have the beneficial effect of applying 
the circuit breakers' protections against excessive volatility to a 
larger group of securities, while at the same time allowing the 
opportunity, during the pilot period, for continued review of the 
operation of the circuit breakers and an assessment of whether the 
pilot should be further expanded or modified.
    FINRA believes that the securities in the Russell 1000 have similar 
trading characteristics to securities included in the S&P 500, and 
therefore the 10% price movement that triggers a trading pause in the 
Phase I Circuit Breaker Pilot is appropriate for Russell 1000 
securities.
    In addition, FINRA proposed to include in the Phase II Circuit 
Breaker Pilot more liquid ETPs--specifically, those with a minimum 
average daily volume of $2,000,000--that tend to have similar trading 
characteristics as securities in the S&P 500 and Russell 1000 and for 
which they believe a 10% circuit breaker trigger is appropriate. To 
assure related ETPs are subject to comparable circuit breakers, any 
ETPs that did not meet the $2,000,000 average daily volume threshold, 
but tracked similar stocks and indices as ETPs meeting this criterion 
and included in the pilot, were proposed for inclusion. ETPs with 
average-daily-volumes of less than $2,000,000, and for which there were 
no high-volume counterparts were not included. Also excluded were 
leveraged ETFs since those products by design are more volatile than 
the underlying stocks they track, and the current proposal only 
contemplates adding securities for which a 10% trigger is appropriate.
    As proposed, the list of ETPs includes those that track broad-based 
equity indices, which FINRA recognizes has caused some debate. For 
example, as described in Section III, concerns have been raised about 
the effect that halting trading in an index-based ETP may have on a 
related index-based option or future. However, FINRA believes that 
including broad-based index ETPs is appropriate so that ETP investors 
are protected should the component securities experience such 
volatility that trading in the broad-based ETP is affected. Because the 
proposal is for a pilot period, FINRA will continue to assess, among 
other things, whether it is appropriate to have a trading pause in 
broad-based index ETPs when there is not a similar trading pause in 
related index-based options or futures.
    In addition, during the pilot period, FINRA will continue to assess 
whether specific stocks or ETPs should be added to, or removed from, 
the list of securities subject to the circuit breakers. FINRA will also 
continue to assess whether the parameters for invoking a trading pause 
continue to be appropriate or should be modified.\13\
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    \13\ See Securities Exchange Act Release No. 62416 (June 30, 
2010), 75 FR 39069 (July 7, 2010) (SR-FINRA-2010-033).

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[[Page 56610]]

III. Discussion of Comments and Commission Findings

    As of August 25, 2010, the Commission received 19 comment letters 
regarding the proposed rule changes. Many commenters supported the 
Phase II Circuit Breaker Pilot and its expansion to the Russell 1000 
and the specified ETPs.\14\ For example, one commenter encouraged the 
Commission to act expeditiously to expand the scope of the trading halt 
rules to securities other than the S&P 500, particularly to ETFs, and 
noted that ETFs experienced significant volatility on May 6, 2010 and 
would benefit from uniform pauses in trading.\15\ Another commenter 
urged the Commission to approve the Phase II Circuit Breaker Pilot as 
quickly as possible, arguing that many of the securities that 
experienced the most extreme trading jolts on May 6, 2010 were not 
included in the Phase I Circuit Breaker Pilot, and that expansion of 
the pilot was appropriate both to protect additional companies from 
potential aberrational price movements and liquidity events affecting 
their securities, and to provide investors with greater certainty about 
the availability of the circuit breakers.\16\ Yet another commenter 
noted that expanding the trading halt pilot to securities in the 
Russell 1000 would protect investors in publicly traded companies not 
in the S&P 500 that experienced severely aberrational trading on May 
6.\17\
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    \14\ See Accenture Letter, Business Roundtable Letter; CCMC 
Letter; ICI Letter; ICI 2 Letter; ICI 3 Letter; Issuer Advisory 
Group Letter; Wellington Letter; Deutsche Bank Letter; SIFMA Letter; 
and BlackRock Letter.
    \15\ See SIFMA Letter.
    \16\ See Business Roundtable Letter.
    \17\ See Accenture Letter.
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    Some commenters raised concerns about the proposed rule changes. 
The two main areas of concern were: (1) The ability of erroneous trades 
to trigger a trading pause; and (2) whether ETPs--particularly broad-
based index products--should be included in the pilot.

1. Erroneous Trades Triggering the Trading Pause

    Several commenters pointed out that, under the circuit breaker 
pilot, erroneous trades can trigger--and have triggered--trading 
pauses, when there otherwise is no extraordinary market volatility.\18\ 
One commenter asserted that under the current circuit breaker logic, 
erroneous trades would have triggered a trading halt at least 238 times 
in the past 18 months.\19\ This same commenter pointed out that, as of 
the date of its letter, three stocks had been halted under the Phase I 
Circuit Breaker Pilot, two of which were triggered on markets with 
prices that were far away from the current national best bid or offer 
(``NBBO'') and prevailing prices at other markets.\20\
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    \18\ See, e.g., Themis Letter; Accenture Letter; Molinete 
Letter; SIFMA Letter; and Angel Letter.
    \19\ See Molinete Letter.
    \20\ Id. (referring to the trading pauses in Citigroup on June 
29, 2010 and in Anadarko Petroleum on July 6, 2010). As of August 
25, stock-specific circuit breakers have been triggered seven times 
in six stocks.
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    Other commenters expressed concern that any trader in the world, 
ill-intentioned \21\ or not, has the power to halt trading in a stock 
simply by printing a trade outside the circuit breaker range on a trade 
reporting facility for the OTC market.\22\ One of these commenters 
suggested that either a minimum number of trades outside the circuit 
breaker range occur before trading is halted, or that the trade first 
be checked for consistency with the NBBO before trading is halted.\23\
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    \21\ The Commission notes that anyone reporting a trade with the 
intention of triggering a trading pause could be charged with 
manipulation, fraud or other violations of the federal securities 
laws.
    \22\ See Themis Letter and Angel Letter.
    \23\ Id.
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    Several commenters concerned with erroneous trades triggering the 
circuit breakers offered alternatives to the ``trading pause'' 
mechanism used in the current pilot. A number of commenters suggested 
that the Commission consider moving to a ``limit up/limit down'' 
approach to moderate market volatility, similar to that utilized in the 
futures markets.\24\ Some commenters also encouraged the Commission to 
consider adopting collars on market orders and eliminating stub 
quotes.\25\ One commenter suggested that the markets trigger the single 
stock circuit breakers off of changes to the NBBO rather than to 
changes in the last trade price.\26\
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    \24\ See SIFMA Letter; Accenture Letter; Wellington Letter; and 
CME 2 Letter. Under this approach, trades could occur within the 
established price bands, so that erroneous trades would largely be 
eliminated. In addition, there would not be a complete trading 
halt--trading would be prevented outside the applicable price band, 
but could continue within it.
    \25\ See SIFMA Letter and CME 2 Letter.
    \26\ See Molinete Letter. As an alternative, this commenter 
suggested requiring at least two consecutive trades outside the NBBO 
to trigger the circuit breaker, and the exclusion of manually-
entered trades from being potential triggers.
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    The Commission believes that the ability of an erroneous trade to 
trigger a trading pause is a concern that FINRA should seek to address 
promptly. The Commission understands that FINRA is working on a variety 
of measures to reduce the instances of erroneous trades and to assure 
that, when they occur, they are resolved promptly through a clear and 
transparent process.\27\ The Commission also notes that, under the 
pilot rules, the Listing Market can exclude a transaction price that 
results from an erroneous execution from triggering a circuit breaker. 
In this regard, the Commission notes that the Listing Markets, pursuant 
to this authority, intend to implement automated processes to help 
prevent trades that may be erroneous--specifically, those outside the 
NBBO--from triggering a circuit breaker.\28\ In addition, the 
Commission understands FINRA is developing more effective ways to 
prevent erroneous OTC trades from being printed on a trade reporting 
facility, and it encourages those efforts as well.\29\ Various 
exchanges have taken steps to ``collar'' market orders, which are 
intended to prevent executions that occur a specified percentage away 
from the last sale,\30\ and Commission staff has been working with 
FINRA on an initiative to prevent stub quotes. The Commission, in 
conjunction with FINRA, will continue to evaluate what further steps 
need to be taken to reduce the likelihood of erroneous trades and to 
improve the efficiency of the pilot. However, the Commission does not 
believe it is appropriate to delay implementation of the Phase II 
Circuit Breaker Pilot pending the conclusion of those efforts.
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    \27\ See SR-BATS-2010-016; SR-BX-2010-040; SR-CBOE-2010-056; SR-
CHX-2010-13; SR-EDGA-2010-03; SR-EDGX-2010-03; SR-FINRA-2010-032; 
SR-ISE-2010-62; SR-NASDAQ-2010-076; SR-NSX-2010-07; SR-NYSE-2010-47; 
SR-NYSEAmex-2010-60; SR-NYSEArca-2010-58 (proposed rule changes to 
amend certain SRO rules to set forth clearer standards and curtail 
SRO discretion with respect to breaking erroneous trades).
    \28\ See Letter from Janet M. Kissane, Senior Vice President--
Legal & Corporate Secretary, NYSE Euronext to Elizabeth M. Murphy, 
Secretary, Commission, dated August 25, 2010; Letter from Thomas P. 
Moran, Associate General Counsel, The NASDAQ Stock Market LLC to 
Elizabeth M. Murphy, Secretary, Commission, dated August 26, 2010. 
The Listing Markets may roll out these new automated processes on a 
staggered basis.
    \29\ See, e.g., FINRA Trade Reporting Notice, dated August 19, 
2010 (issuing new guidance on the use of the weighted-average price/
special pricing formula (.W) trade modifier for reporting certain 
types of OTC trades in NMS stocks to FINRA).
    \30\ See, e.g., Securities Exchange Act Release Nos. 62485 (July 
13, 2010), 75 FR 41914 (July 19, 2010) (SR-NYSEArca-2010-67); 60371 
(July 23, 2009), 74 FR 38075 (July 30, 2009) (SR-NASDAQ-2009-70).
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2. Inclusion of ETPs

    Many commenters addressed the inclusion of ETPs in the pilot 
program.\31\ Several supported the proposed expansion of the Phase II

[[Page 56611]]

Circuit Breaker Pilot to include ETPs.\32\ One of these commenters 
stated that ETFs experienced significant volatility on May 6, and would 
benefit from a uniform trading pause.\33\ Another commenter noted that 
the price of an ETF is typically highly correlated to the market price 
of its basket of component securities.\34\ Under normal circumstances, 
when trading has been halted for one or two component securities, an 
ETF may experience a slight deviation from the price of its basket 
because of the challenge of pricing the non-trading security, and may 
trade with a wider spread to account for the associated risk. When 
multiple underlying securities are affected, however, the correlation 
between the prices of an ETF and its underlying basket may break down 
and the ETF may experience more severe price dislocation.\35\ While 
this commenter thought that a different circuit breaker trigger may be 
appropriate for ETFs, it nonetheless encouraged the Commission to 
include all ETFs in the pilot where a substantial number of the 
component securities are subject to the circuit breakers.\36\ Doing 
otherwise, in its view, creates risks that ETFs could again suffer 
disproportionately during a market event similar to that of May 6.\37\
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    \31\ See Accenture Letter; Android Alpha Fund Letter; BlackRock 
Letter; Business Roundtable Letter; CME Letter; CME 2 Letter; CCMC 
Letter; ICI Letter; ICI 2 Letter; ICI 3 Letter; Molinete Letter; 
SIFMA Letter.
    \32\ See Accenture Letter; BlackRock Letter; Business Roundtable 
Letter; CCMC Letter; ICI Letter; ICI 2 Letter; ICI 3 Letter; SIFMA 
Letter.
    \33\ See SIFMA Letter at 2.
    \34\ See ICI Letter and ICI 2 Letter.
    \35\ Id.
    \36\ See ICI Letter. In a subsequent letter, that commenter 
supported examining the connection between price discovery in the 
equities and the futures markets, and potentially making rules 
consistent across markets. See ICI 2 Letter. According to this 
commenter, however, such an examination should not prevent including 
broad-based index ETFs in the pilot program. Id.
    \37\ See ICI 2 Letter.
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    One commenter supported the inclusion of ETFs in the pilot program, 
in part because halting trading in the underlying component securities, 
but not in the ETF, would hinder the arbitrage mechanism that is 
critical to the ability of ETFs to track the performance of their 
underlying basket or benchmark index.\38\ According to this commenter, 
if an ETF were allowed to continue to trade while trading in the 
majority of its underlying securities were halted, the arbitrage 
mechanism would not work effectively, with the result that liquidity 
for the ETF would diminish greatly, and perhaps lead to a collapse in 
price similar to that which occurred on May 6.\39\
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    \38\ See BlackRock Letter. According to the commenter, this 
arbitrage mechanism generally requires liquidity providers to sell a 
basket of stocks equivalent to an ETF's underlying portfolio (or a 
correlated derivative) as a hedge when purchasing ETF shares.
    \39\ Id. This commenter did, however, question the exclusion of 
lower-volume ETFs from the Phase II Circuit Breaker Pilot, and urged 
that these ETFs be included in the pilot at the earliest 
opportunity. See discussion on pages 6-7 describing the rationale 
for selecting the list of ETPs for inclusion in the pilot program.
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    Other commenters criticized various aspects of the application of 
the proposed rule change to ETPs. One commenter described certain 
ETFs--such as the S&P 500 SPDR (SPY)--as ``systemically important,'' 
and expressed concern that halting trading in these ETFs, especially as 
a result of erroneous trades, might destabilize markets. Because the 
SPY, for example, is used as a hedging vehicle in many trading 
strategies, halting trading in it could cause liquidity providers 
broadly to withdraw from the market, increasing volatility and perhaps 
leading to a chain reaction like that witnessed on May 6.\40\ This 
commenter did not believe that allowing ETFs to continue to trade while 
some of the underlying component securities were halted would be 
detrimental, because market participants would determine their own fair 
value of the halted component securities.\41\
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    \40\ See Molinete Letter at 4.
    \41\ Id. at 4-5.
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    Another commenter expressed significant concern with the proposed 
expansion of the pilot to broad-based equity index ETFs, as it believed 
there could be potentially significant disruptions to trading across 
related markets.\42\ This commenter noted that the indices underlying 
the most active ETFs are the same as those underlying the most active 
cash index options, index futures, and options on ETFs.\43\ If a 
different circuit breaker mechanism applied to broad-based equity index 
ETFs and ETF options than applied to index futures and index options, 
or differed from the overall market-wide circuit breakers, the 
commenter feared this could lead to further market stress during 
periods of turbulence, perhaps impeding liquidity and exacerbating risk 
management challenges.\44\ In addition, the commenter thought that the 
inability of market makers to hedge using equity index ETFs during a 
trading pause could lead to their withdrawing liquidity across all 
markets, including in the E-mini index futures.\45\ Accordingly, the 
commenter believed that the circuit breakers applicable to equity 
index-based ETFs (as well as index futures, index options, options on 
ETFs, and swaps) should be consistent with both the methodology and 
levels of the market-wide circuit breakers.\46\ Specifically, the 
commenter recommended the adoption of uniform price limits across all 
broad-based index products based upon the S&P 500, the DJIA, and the 
NASDAQ 100, which would preclude trading beyond the enumerated limit 
but not within it.\47\ This commenter also recommended that automated 
risk and volatility mitigation mechanisms be implemented in place of 
trading halts in individual securities.\48\
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    \42\ See CME Letter and CME 2 Letter. This commenter expressed 
further concerns with the prospect of multiple constituent stocks in 
an index being halted without the market-wide circuit breaker being 
triggered. The commenter thought this would create complexity and 
confusion in understanding the index calculation. In addition, the 
commenter was of the view that the halting of high capitalization, 
highly-liquid index components would be disruptive because it could 
affect whether the index triggers a market-wide circuit breaker, the 
intra-day index values circulated for risk management purposes may 
not be reflective of the true value of the underlying market, and 
large liquidity providers in index futures and ETFs may have 
difficulty hedging with the result that they withdraw from the 
market.
    \43\ Id. The commenter also noted that these markets are very 
closely linked and the absence of effective coordination across 
comparable markets was one factor cited by many as having 
contributed to certain market issues experienced on May 6. The 
Commission addresses issues of cross-market linkage in its 
discussion infra.
    \44\ Id.
    \45\ CME Letter.
    \46\ CME Letter. This commenter also noted that, while 
approximately 70% of the trades broken on May 6, 2010 were in ETFs, 
they were not in the most liquid domestic, large cap index products.
    \47\ CME 2 Letter. These price limits would be established at 
the 5%, 10% and 20% levels, and would be implemented for a 10 minute 
period, after which trading would continue to the next applicable 
limit.
    \48\ Id. Specifically, the commenter recommended that all 
markets adopt: (1) automated means--similar to the commenter's stop 
logic functionality--to briefly pause the market in the event that 
cascading sell orders precipitate a material market decline because 
of a transitory dearth of liquidity; (2) functionality--similar to 
the commenter's protection point functionality--to automatically 
apply limit prices to all orders, including market and stop orders; 
and (3) automated price banding functionality and maximum order size 
restrictions to help prevent erroneous trades. For as long as single 
stock circuit breakers continue to be employed, however, the 
commenter believed regulators and the markets should establish 
uniform policies and procedures to address situations where the 
computation of the market-wide circuit breaker index value is 
negatively affected due to the triggering of stock specific circuit 
breakers on the component securities.
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    The Commission believes that, on balance, the inclusion of ETPs, 
including broad-based index equity ETFs, in the Phase II Circuit 
Breaker Pilot is warranted and consistent with the Act. The Commission 
notes that there are a number of scenarios in which the application of 
a circuit breaker to trading in an ETF would promote market stability. 
For example, if an ETF triggers a circuit breaker when none of its 
component stocks is

[[Page 56612]]

experiencing abnormal moves, then it is likely that the ETF is 
suffering from a temporary liquidity imbalance. In that case, the ETF 
would no longer be suitable for use as a hedging instrument since its 
price would no longer reflect an accurate consensus market value of the 
ETF or its underlying stocks. By pausing the ETF under these 
circumstances, the Exchanges would allow liquidity to rebuild and 
provide time for the market to self-correct without allowing the 
aberrant price of the ETF to adversely affect the trading and pricing 
of the underlying stocks, other ETFs or other related products.
    In another scenario, an ETF might trigger a circuit breaker, even 
though its component stocks have not, because the ETF is leading its 
underlying stocks in price discovery. In that case, the prices of many 
of the underlying stocks may follow, triggering their own circuit 
breakers shortly after the ETF does. In a broad market event such as 
this, the net result would be that trading in the ETF and individual 
stocks have each been paused, providing time for the market as a whole 
to re-evaluate prices.
    In yet another scenario, a number of individual component stocks 
might trigger their circuit breakers even though the related ETF has 
not yet done so. In that case, different market participants may very 
well have differing opinions on the market value for the ETF because 
they will be required to estimate the value of those component stocks 
that have been paused. If only a small number of component stocks is 
paused (perhaps due to some temporary liquidity imbalances in those 
stocks) then there likely would be minimal effect on the ETF, and the 
ETF circuit breakers appropriately would not be triggered. But if a 
large number of component stocks trigger halts, the market likely is 
experiencing a broad-based move, either for fundamental reasons, or 
because of a large-scale liquidity imbalance similar to that of May 6. 
As noted above, if many component stocks of an ETF are paused, but the 
ETF itself continues to trade, the arbitrage relationship between the 
ETF and its component stocks likely will break down as market 
participants find they cannot hedge their exposures and, as a 
consequence, cease to provide liquidity. Without a circuit breaker 
mechanism that also applies to ETFs, the ETF could experience excessive 
volatility that is not necessarily driven by the prices of its 
underlying stocks. By pausing the ETF, market participants would be 
given time to re-evaluate prices and replenish liquidity as needed.
    The Commission acknowledges that a variety of ETFs do indeed trade 
without incident when most, and sometimes all, of their underlying 
components are not trading (e.g., ETFs on international stocks). 
However, market makers and other participants trading these ETFs 
account for this known and permanent structural difference by building 
alternative methods for hedging and pricing into their trading models. 
Market participants trading ETFs for which the component stocks 
normally trade at the same time would not necessarily have the 
opportunity to implement new hedging and pricing strategies in real 
time if underlying component stocks were suddenly paused. Rather, they 
would most likely withdraw from the market leaving the ETF with little 
liquidity and even further need for a trading pause.\49\
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    \49\ The Commission notes that a pause in the ETF could also 
affect trading in underlying component stocks that were not 
otherwise halted to the extent that the ETF was no longer available 
as a hedging mechanism.
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    The above arguments demonstrating the need to couple pauses in ETFs 
with pauses in underlying stocks are equally applicable to the futures 
market, and the Commission acknowledges the comments and concerns of 
the CME for consistent treatment across instrument types. However, the 
Commission notes that the CME's markets already have mechanisms for 
limiting or pausing trading, and thus some inconsistency exists today 
between the two markets. Maintaining the status quo, moreover, would 
leave ETFs without a trading pause mechanism. In addition, the 
Commission notes that there will need to be substantial work to 
determine how best to make the volatility constraints in the futures 
markets and the securities markets consistent.
    Commenters have also raised related concerns that a pause in a 
broad-based ETF (such as the SPY) could lead to significant liquidity 
pressures on other index-based products in the futures market (such as 
the E-mini).\50\ Although this is a potential point of concern, as 
noted above, the futures markets already have in place volatility 
mechanisms that should help mitigate the effect of such an event. 
Moreover, it should be noted that currently there could be a pause on 
the futures market (e.g., in the E-mini) which could create liquidity 
pressure for corresponding ETFs--but there is currently no mechanism to 
protect the ETF against aberrant prices as a result of such liquidity 
pressures.
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    \50\ See CME Letter.
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    In response to the comment that the Commission instead implement 
automated risk and volatility mitigation mechanisms--such as price 
banding or stop logic functionality--the Commission notes that, even as 
the circuit breaker pilot is being expanded, the Commission is 
simultaneously exploring possible alternatives to a circuit breaker 
approach that may include price limit bands or other mechanisms 
described by the commenters.
    One commenter noted that the proposal would exclude many ETFs with 
trading volumes below the criteria set by FINRA, although such ETFs 
were significantly affected in the cancelled trades of May 6.\51\ The 
Commission acknowledges that fact, but notes that, as FINRA has 
indicated, the potential application of the circuit breakers to less 
liquid securities is more complex, as different triggering thresholds 
may be appropriate for them. As the pilot progresses, the Commission 
will work with FINRA to consider expanding the circuit breakers to 
cover additional securities in an appropriate manner.
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    \51\ See BlackRock Letter.
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    The Commission acknowledges the point made by commenters that 
broad-based index products were not significantly implicated in the 
cancelled trades on May 6.\52\ However, the Commission notes that 
broad-based index products did experience substantial volatility on May 
6 \53\ and, like other securities, could benefit from the protections 
of a circuit breaker. In addition, a sudden change in price, due to a 
loss of liquidity or otherwise, to a widely traded ETF could have an 
adverse market-wide effect even more far-reaching than that of May 6. 
It is important that the use of circuit breakers not be limited to only 
those ETFs that happened to have experienced severe dislocations on May 
6, since there is no fundamental reason why broad-based ETFs could not 
experience a similar liquidity crisis. In addition, there were no 
circuit breakers in effect for underlying stocks on May 6. If a similar 
event occurred when many underlying stocks in an index were halted by 
circuit breakers, broad-based ETFs could experience greater volatility 
than occurred on May 6.
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    \52\ See CME Letter.
    \53\ See Joint Report, supra note 8, at 39 (noting that many 
ETFs ``experienced extreme daily lows'' on May 6, and that a 
``significant number of ETFs'' experienced extreme daily highs on 
May 6).
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3. Other Areas of Comment

    Other areas of comment included potential ways to expand or modify 
the circuit breaker pilot going forward,\54\ the

[[Page 56613]]

need to carefully study the effect of the pilot,\55\ the effect and 
continued advisability of individual market volatility moderators in 
addition to the uniform single-stock circuit breakers,\56\ and possible 
modifications to the market-wide circuit breakers.\57\
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    \54\ See Angel Letter (recommending that the trading pause be 
expanded to cover the open, close, and after-hours trading); ICI 
Letter (recommending examining whether a different circuit breaker 
trigger is appropriate for ETFs); Wellington Letter (recommending 
that the Commission require the Exchanges to continuously disclose 
the high/low trigger of a security and its maximum remaining life).
    \55\ See Android Alpha Fund Letter.
    \56\ See Deutsche Bank Letter.
    \57\ See CME 2 Letter; SIFMA Letter.
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    With regard to expanding or modifying the circuit breaker pilot, as 
noted above, the Commission intends to continue working with FINRA to 
consider expanding the pilot to include additional securities, or 
modifying the circuit breaker mechanism or pursuing other approaches to 
moderating market volatility, in the coming months. In addition, as 
noted in the Joint Report, the Commission currently is evaluating the 
extent to which individual market volatility moderators exacerbated the 
market instability that occurred on May 6, 2010, and expects to develop 
appropriate policy recommendations based on the outcome of that 
analysis. Finally, as noted in the Joint Report, the Commission intends 
to work with the CFTC to consider whether modifications to the existing 
market-wide circuit breakers are warranted in light of the events of 
May 6. While all of these issues warrant further study in the coming 
months, the Commission does not believe they provide a basis for not 
approving the Phase II Circuit Breaker Pilot at this time. The fact 
that better alternatives to address inordinate market volatility 
ultimately may be developed does not provide a basis for the Commission 
not to approve FINRA's proposal if, as the Commission believes, the 
proposed rule change is consistent with Section 15A(b)(6) of the Act.

4. Findings

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities association. In 
particular, the Commission finds that the proposal is consistent with 
the provisions of Section 15A(b)(6) of the Act,\58\ which requires, 
among other things, that FINRA rules must be designed to prevent 
fraudulent and manipulative acts and practices, to promote just and 
equitable principles of trade and, in general, to protect investors and 
the public interest.\59\
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    \58\ 15 U.S.C. 78o-3(b)(6).
    \59\ In approving the proposed rule change, the Commission notes 
that it has considered the proposed rule's impact on efficiency, 
competition, and capital formation. 15 U.S.C. 78c(f).
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    The proposed rule changes will expand the trading pause pilot to 
include the securities in the Russell 1000 and specified ETPs. The 
Commission believes that expanding the uniform, market-wide trading 
pauses will serve to prevent potentially destabilizing price volatility 
and will thereby help promote the goals of investor protection and fair 
and orderly markets.

IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\60\ that the proposed rule change (SR-FINRA-2010-033) be, and 
hereby is, approved.
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    \60\ 15 U.S.C. 78s(b)(2).

    By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2010-23073 Filed 9-15-10; 8:45 am]
BILLING CODE 8010-01-P

