I. Introduction

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”) 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] proposed rule changes to amend certain of their respective rules to expand the trading pause pilot in individual stocks comprising the S&P 500® 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® Index (“Russell 1000”) and specified Exchange Traded Products (“ETPs”).^[4] The proposed rule changes were 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] ( printed page 56619) The NYSE responded to the comments in a letter dated July 23, 2010,^[7] and in a letter dated August 25, 2010.^[8] Nasdaq submitted a response on August 26, 2010.^[9]

The Commission finds that the proposals are consistent with Section 6(b)(5) of the Act,^[10] 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 fair and orderly markets. This order approves the proposed rule changes.

II. Description of the Proposals

On May 6, 2010, the U.S. equity markets experienced a severe disruption.^[11] Among other things, the prices of a large number of individual securities suddenly declined by significant amounts in a very short time 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 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.

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 proposed rule changes by the Exchanges to pause trading during periods of extraordinary market volatility in S&P 500 stocks (the “Phase I Circuit Breaker Pilot”).^[12] The rules 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. The Listing Markets are required to notify the other Exchanges and market participants 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, the other Exchanges are required to pause trading in the security on their markets.

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, the other Exchanges may resume trading.^[13]

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.^[14] In the approval order for the Phase I Circuit Breaker Pilot, the Commission agreed that consideration should be given by the Exchanges 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.

Under the current proposal, the Exchanges propose 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. The Exchanges believe 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.

The Exchanges believe 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. Based on the analyses of certain of the Exchanges, the number of times that the trading pause would be triggered for Russell 1000 ( printed page 56620) securities would be similar to the number of instances for S&P 500 securities.

In addition, the Exchanges proposed to include in the Phase II Circuit Breaker Pilot the 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.^[15] In addition, to assure related ETPs are subject to comparable circuit breakers, the Exchanges proposed to include any ETP that did not meet the $2,000,000 average daily volume threshold, but tracked similar stocks and indices as ETPs meeting this criterion and proposed to be included in the pilot. 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.^[16]

As proposed, the list of ETPs includes those that track broad-based equity indices, which the Exchanges recognize 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, the Exchanges believe 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, the Exchanges 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, the Exchanges 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. The Exchanges will also continue to assess whether the parameters for invoking a trading pause continue to be appropriate or should be modified.^[17]

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.^[18] 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.^[19] 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.^[20] 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.^[21]

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.^[22] 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.^[23] 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.^[24]

Other commenters expressed concern that any trader in the world, ill-intentioned ^[25] 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.^[26] 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.^[27]

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.^[28] Some commenters also encouraged the Commission to consider adopting collars on market orders and eliminating stub quotes.^[29] One commenter suggested that the markets trigger the single stock circuit breakers ( printed page 56621) off of changes to the NBBO rather than to changes in the last trade price.^[30]

The Commission believes that the ability of an erroneous trade to trigger a trading pause is a concern that the Exchanges should seek to address promptly. The Commission understands that the Exchanges are 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.^[31] 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.^[32] 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,^[33] and Commission staff has been working with the Exchanges on an initiative to prevent stub quotes. The Commission, in conjunction with the Exchanges, 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.

2. Inclusion of ETPs

Many commenters addressed the inclusion of ETPs in the pilot program.^[34] Several supported the proposed expansion of the Phase II Circuit Breaker Pilot to include ETPs.^[35] One of these commenters stated that ETFs experienced significant volatility on May 6, and would benefit from a uniform trading pause.^[36] Another commenter noted that the price of an ETF is typically highly correlated to the market price of its basket of component securities.^[37] 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.^[38] 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.^[39] Doing otherwise, in its view, creates risks that ETFs could again suffer disproportionately during a market event similar to that of May 6.^[40]

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.^[41] 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.^[42]

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.^[43] 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.^[44]

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.^[45] This commenter noted that ( printed page 56622) 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.^[46] 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.^[47] 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.^[48] 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.^[49] 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.^[50] This commenter also recommended that automated risk and volatility mitigation mechanisms be implemented in place of trading halts in individual securities.^[51]

In its response to comments, NYSE stated that the “prompt review and implementation of revised and coordinated market wide circuit breakers is * * * a high priority.” ^[52] NYSE also indicated that it would continue to review the operation of the pilot, including its effect on how index-based products trade across multiple markets, and would propose “such changes as may be warranted for those securities.” ^[53]

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 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 because 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.^[54]

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, ( printed page 56623) 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 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).^[55] 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.

NYSE also recognized these concerns in its response to comments, and committed to working with regulators and other markets in coordinating alerts to trading interruptions “so consistent application of pauses will be effected.”^[56] NYSE also described “the prompt review and implementation of revised and coordinated market wide circuit breakers” as “a high priority.”^[57]

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 the Exchanges and FINRA, although such ETFs were significantly affected in the cancelled trades of May 6.^[58] The Commission acknowledges that fact, but notes that, as the Exchanges have 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 the SROs to consider expanding the circuit breakers to cover additional securities in an appropriate manner.

The Commission acknowledges the point made by commenters that broad-based index products were not significantly implicated in the cancelled trades on May 6.^[59] However, the Commission notes that broad-based index products did experience substantial volatility on May 6 ^[60] 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.

3. Other Areas of Comment

Other areas of comment included potential ways to expand or modify the circuit breaker pilot going forward,^[61] the need to carefully study the effect of the pilot,^[62] the effect and continued advisability of individual market volatility moderators in addition to the uniform single-stock circuit breakers,^[63] and possible modifications to the market-wide circuit breakers.^[64]

With regard to expanding or modifying the circuit breaker pilot, as noted above, the Commission intends to continue working with the Exchanges 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 the Exchanges' proposals if, as the Commission believes, the proposed rule changes are consistent with Section 6(b)(5) of the Act.

4. Findings

The Commission finds that the proposed rule changes are consistent with the requirements of the Act and the rules and regulations thereunder applicable to national securities exchanges. In particular, the Commission finds that the proposals are consistent with Section 6(b)(5) of the Act,^[65] which among other things requires that the rules of national securities exchanges be designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and in general, to protect investors and the public interest.^[66]

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,^[67] that the proposed rule changes (SR-BATS-2010-018; SR-BX-2010-044; SR- ( printed page 56624) CBOE-2010-065; SR-CHX-2010-14; SR-EDGA-2010-05; SR-EDGX-2010-05; SR-ISE-2010-66; SR-NASDAQ-2010-079; SR-NYSE-2010-49; SR-NYSEAmex-2010-63; SR-NYSEArca-2010-61; SR-NSX-2010-08) be, and hereby are, approved.