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SEC Eases Stock Trading Curbs News The Securities and Exchange Commission (SEC) on July 19 agreed to loosen some of the stock markets' so-called "circuit breakers." The halts would be shorter but no changes were made to the 50-point collar.
Analysis What are "Circuit Breakers"? They are mechanisms aimed at averting panic selling of securities. They were introduced after the October 1987 stock market crash when the DJIA lost 508 points, or 22% , in a day. There are restrictions on two types of trading: on trading of individual stocks and "index arbitrage." Under the old rules, the former is introduced in stages as the magnitude of the stock market drop increases. For example, all stock markets are required to shut down for an hour if the Dow Jones industrial average sheds 250 points in a day. A two-hour halt occurs after a 400-point fall in the Dow. So far, such action hasn't been necessary. The second type involves restrictions on index arbitrage, or "arb" (see definitions below). Let’s look at the motivation for such a transaction using the S&P 500 as an illustration. The value of a basket of assets should be equal to the sum of the components. Thus, the market value of the S&P 500 index should be equal to the sum of the relative values of each of the 500 stocks comprising the index. Thus, whenever these two quantities are not equal there is an arbitrage opportunity. Suppose the index is sold at a higher price than the sum of its components. What should you do? You should sell the over-priced asset and use the proceeds from the sale to buy the under-priced basket. Since you are simultaneously buying and selling equivalent assets, you will only realize a profit if the prices are not identical. Your guess is correct. You as an individual investor will not be able to realize profits from such a transaction as these "arbitrageurs" make their living on such discrepancies, but at the same time their actions are a service to the average investor as they prevent the value of these two equivalent assets from getting out of whack. The rule that was not changed prohibits firms from executing such computerized transactions when the DJIA rises or falls 50 points, thus the name "50-point collar." Regulators enacted the curbs because index arbitrage was blamed for exacerbating the 1987 stock market crash.
The new rules Trading will be halted for 30 minutes instead of an hour when the Dow falls 250 points or more. Trading will be halted for one hour instead of two when the Dow falls 400 points. And the SEC eliminated plans for a brief after-hours trading session if either circuit breaker came late enough in the day to force temporary losing of the markets. The SEC's rule changes apply to the NYSE, the American Stock Exchange (AMEX) and other smaller regional markets, such as the Pacific Stock Exchange. The Nasdaq Stock Market informally obeys the trading halts as well, although it's not required to. The rule, which was not changed, prohibits firms from executing such computerized transactions when the DJIA rises or falls 50 points, thus the name "50-point collar." Regulators enacted the curbs because index arbitrage was blamed for exacerbating the 1987 stock market crash.
Why The Change? In 1988, when the NYSE first began testing the new trading curbs, a 250-point plunge in the Dow would have represented a 12 percent decline in the Dow average. Today, a 250-point drop represents only a 4.4 percent decline. Supporters, including NYSE officials, were quoted by the LA Times as saying that the new rules "would curb disorderly markets though they wouldn’t stop stock prices from falling."
Some Definitions Arbitrage (risk arbitrage) Simultaneous purchase of a security and sale of another to generate a risk-free profit. Index A yardstick to measure change from a base year. Commonly used equity indexes are the Dow Jones Industrial Average (DJIA) and the Standard & Poors’ 500 (S&P 500).
By Alex Tajirian |
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