Self Regulation and Circuit Breakers

Much of the securities industry relies on self-regulation. The SEC delegates to secondary exchanges much of the responsibility for day-to-day oversight of trading. Similarly, the National Association of Securities Dealers oversees trading of OTC securities. The Association for Investment Management and Research's Code of Ethics and Professional Conduct sets out principles that govern the behavior of Chartered Financial Analysts, more commonly referred to as CFAs. The nearby box presents a brief outline of those principles.

The market collapse of 1987 prompted several suggestions for regulatory change. Among these was a call for "circuit breakers" to slow or stop trading during periods of extreme volatility. Some of the current circuit breakers are as follows:

• Trading halts. If the Dow Jones Industrial Average falls by 10%, trading will be halted for one hour if the drop occurs before 2:00 p.m. (Eastern Standard Time), for one-half hour if the drop occurs between 2:00 and 2:30, but not at all if the drop occurs after 2:30. If the Dow falls by 20%, trading will be halted for two hours if the drop occurs before 1:00 p.m., for one hour if the drop occurs between 1:00 and 2:00, and for the rest of the day if the drop occurs after 2:00. A 30% drop in the Dow would close the market for the rest of the day, regardless of the time.

• Collars. When the Dow moves 210 points in either direction from the previous day's close, Rule 80A of the NYSE requires that index arbitrage orders pass a "tick test." In a failing market, sell orders may be executed only at a plus tick or zero-plus tick, meaning that the trade may be done at a higher price than the last trade (a plus tick) or at the last price if the last recorded change in the stock price is positive (a zero-plus tick). The rule remains in effect for the rest of the day unless the Dow returns to within 100 points of the previous day's close.

The idea behind circuit breakers is that a temporary halt in trading during periods of very high volatility can help mitigate informational problems that might contribute to excessive price swings. For example, even if a trader is unaware of any specific adverse economic news, if she sees the market plummeting, she will suspect that there might be a good reason for the price drop and will become unwilling to buy shares. In fact, the trader might decide to sell shares to avoid losses. Thus feedback from price swings to trading behavior can exacerbate market movements. Circuit breakers give participants a chance to assess market fundamentals while prices are temporarily frozen. In this way, they have a chance to decide whether price movements are warranted while the market is closed.

EXCERPTS FROM AIMR STANDARDS OF PROFESSIONAL CONDUCT

Standard I: Fundamental Responsibilities

Members shall maintain knowledge of and comply with all applicable laws, rules, and regulations including AIMR's Code of Ethics and Standards of Professional Conduct.

Standard II: Responsibilities to the Profession

• Professional Misconduct. Members shall not engage in any professional conduct involving dishonesty, fraud, deceit, or misrepresentation.

• Prohibition against Plagiarism.

Standard III: Responsibilities to the Employer

• Obligation to Inform Employer of Code and Standards. Members shall inform their employer that they are obligated to comply with these Code and Standards.

• Disclosure of Additional Compensation Arrangements. Members shall disclose to their employer all benefits that they receive in addition to compensation from that employer.

Standard IV: Responsibilities to Clients and Prospects

• Investment Process and Research Reports. Members shall exercise diligence and thoroughness in making investment recommendations . . . distinguish between facts and opinions in research reports . . . and use reasonable care to maintain objectivity.

• Interactions with Clients and Prospects. Members must place their clients' interests before their own.

• Portfolio Investment Recommendations. Members shall make a reasonable inquiry into a client's financial situation, investment experience, and investment objectives prior to making appropriate investment recommendations. . . .

• Priority of Transactions. Transactions for clients and employers shall have priority over transactions for the benefit of a member.

• Disclosure of Conflicts to Clients and Prospects. Members shall disclose to their clients and prospects all matters, including ownership of securities or other investments, that reasonably could be expected to impair the members' ability to make objective recommendations.

Standard V: Responsibilities to the Public

• Prohibition against Use of Material Nonpublic [Inside] Information. Members who possess material nonpublic information related to the value of a security shall not trade in that security.

• Performance Presentation. Members shall not make any statements that misrepresent the investment performance that they have accomplished or can reasonably be expected to achieve.

Source: Abridged from The Standards of Professional Conduct of the Association for Investment Management and Research.

Of course, circuit breakers have no bearing on trading in non-U.S. markets. It is quite possible that they simply have induced those who engage in program trading to move their operations into foreign exchanges.

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