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SEC asks exchanges to devise new trading rules

Securities and Exchange Commission Chairman Mary Schapiro met Monday with the heads of six U.S. exchanges.
Securities and Exchange Commission Chairman Mary Schapiro met Monday with the heads of six U.S. exchanges. (Harry Hamburg/associated Press)
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By Zachary A. Goldfarb
Washington Post Staff Writer
Tuesday, May 11, 2010

Federal regulators on Monday gave U.S. stock exchanges 24 hours to devise a market-wide plan to stop or slow trading in stocks that are falling rapidly, in an effort to avoid a repeat of Thursday's violent swings in the financial markets, according to sources familiar with the matter.

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During a meeting Monday with the heads of six U.S. exchanges, Securities and Exchange Commission Chairman Mary Schapiro demanded quick action on developing industry rules on when trading should be stopped in markets as well as individual stocks, the sources said.

The agency also wants to ensure that every U.S. exchange has common rules for canceling trades affected by market errors, according to the sources, who spoke on the condition of anonymity because the meeting was private.

"The parties agreed on a structural framework, to be refined over the next day, for strengthening circuit breakers and handling erroneous trades," a statement from the SEC said.

Regulators from several agencies have spent the past several days analyzing millions of trades but have yet to determine what was behind Thursday's volatility. On that day, the Dow Jones industrial average rapidly fell nearly 1,000 points before rebounding 700 points, as many individual stocks suffered dramatic plunges before reclaiming most of their declines.

Although regulators have not pinpointed the cause, it has become increasingly clear that the stock exchanges' disparate rules contributed to the market chaos.

One way to look at what happened Thursday -- as described by a source deeply familiar with the exchange system -- is to think about U.S. stock exchanges as a series of pools connected by canals.

Each pool has buy and sell orders coming into it. If a pool cannot offer the best price in the market, it reroutes the order to the pool with the best price. This process happens all day long, and keeps the pools at a healthy balance with one another.

On Thursday, investors were selling shares aggressively because of concerns about a potential default by Greece and a financial contagion in Europe. As several stocks declined sharply under heavy selling pressure, the New York Stock Exchange, one of the largest pools, stopped or slowed trading in particular stocks.

As part of that process, the NYSE held on to "buy" orders, in the hopes that it could gather enough of them to meet the selling demand. "Sell" orders that came to the NYSE were rerouted to other exchanges, which were not required to slow trading. Those other exchanges were soon overflowing with sell orders and didn't have enough buy orders to meet them, leading to the rapid decline in prices.

The declines were exacerbated by Wall Street's heavy reliance on computer-trading programs that make lightning-fast decisions, based on complex mathematical rules, about what to buy and sell without human input.

The exchanges that met with Schapiro on Monday included Nasdaq, BATS, Direct Edge, International Securities Exchange and Chicago Board Options Exchange. Some of them -- such as BATS and Direct Edge -- have emerged as serious rivals to more established exchanges in recent years.

But these are only a few of the platforms for trading that have proliferated, making it certain that whatever plan the exchanges present to the SEC could be difficult to implement.

"It's challenging to coordinate trading halts across the market and it's even more challenging to coordinate openings after a trading halt," said Robert L. D. Colby, who recently stepped down as deputy director of trading and markets at the SEC. "The trading is dispersed across 30 or so trading markets."

The SEC will have to sign off on any proposal, which could take at least a few weeks to implement.

Schapiro, the leaders of the exchanges and Commodity Futures Trading Commission Chairman Gary Gensler also met with Treasury Secretary Timothy F. Geithner on Monday to discuss Thursday's events.

Schapiro, Gensler and representatives of the exchanges will address a hearing on Tuesday afternoon to be held by the House Financial Services Committee on last week's volatility.

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