Notice2024-21508
Joint Industry Plan; Order Disapproving the Twenty-Third Amendment to the National Market System Plan To Address Extraordinary Market Volatility
Primary source
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Published
September 20, 2024
Issuing agencies
Securities and Exchange Commission
Full Text
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<title>Federal Register, Volume 89 Issue 183 (Friday, September 20, 2024)</title>
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[Federal Register Volume 89, Number 183 (Friday, September 20, 2024)]
[Notices]
[Pages 77203-77208]
From the Federal Register Online via the Government Publishing Office [<a href="http://www.gpo.gov">www.gpo.gov</a>]
[FR Doc No: 2024-21508]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-101036; File No. 4-631]
Joint Industry Plan; Order Disapproving the Twenty-Third
Amendment to the National Market System Plan To Address Extraordinary
Market Volatility
September 16, 2024.
I. Introduction
On October 24, 2023, NYSE Group, Inc., on behalf of the
Participants \1\ to the National Market System Plan to Address
Extraordinary Market Volatility (``Plan''), filed with the Securities
and Exchange Commission (``Commission''), pursuant to section 11A(a)(3)
of the Securities Exchange Act of 1934 (``Act'' or ``Exchange Act'')
\2\ and Rule 608 thereunder,\3\ a proposal (``Proposal'' or ``Proposed
Amendment'') to amend the Plan. The Proposed Amendment was published
for comment in the Federal Register on November 21, 2023.\4\ On
February 15, 2024, the Commission instituted proceedings pursuant to
Rule 608(b)(2)(i) of Regulation NMS \5\ to determine whether to approve
or disapprove the Proposed Amendment or to approve the Proposed
Amendment with any changes or subject to any conditions the Commission
deems necessary or appropriate.\6\ On May 14, 2024, the Commission
designated a longer period within which to conclude proceedings
regarding the Proposed Amendment.\7\ On July 18, 2024, the Commission
designated a longer period for Commission action on the Proposed
Amendment.\8\
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\1\ The Participants are: Cboe BYX Exchange, Inc., Cboe BZX
Exchange, Inc., Cboe EDGA Exchange, Inc., Cboe EDGX Exchange, Inc.,
the Financial Industry Regulatory Authority, Inc., Investors
Exchange LLC, Long-Term Stock Exchange, Inc., MEMX LLC, MIAX Pearl,
LLC, NASDAQ BX, Inc., NASDAQ PHLX LLC, The NASDAQ Stock Market LLC,
New York Stock Exchange LLC, NYSE American LLC, NYSE Arca, Inc.,
NYSE Chicago, Inc., and NYSE National, Inc. (collectively,
``Participants'').
\2\ 15 U.S.C. 78k-1(a)(3).
\3\ 17 CFR 242.608.
\4\ See Securities Exchange Act Release No. 98928 (Nov. 14,
2023), 88 FR 81131 (``Notice''). Comments received in response to
the Notice can be found on the Commission's website at: <a href="https://www.sec.gov/comments/4-631/4-631.htm">https://www.sec.gov/comments/4-631/4-631.htm</a>.
\5\ 17 CFR 242.608(b)(2)(i).
\6\ See Securities Exchange Act Release No. 99545 (Feb. 15,
2024), 89 FR 13389 (Feb. 22, 2024) (``OIP''). Comments received in
response to the OIP can be found on the Commission's website at:
<a href="https://www.sec.gov/comments/4-631/4-631.htm">https://www.sec.gov/comments/4-631/4-631.htm</a>.
\7\ See Securities Exchange Act Release No. 100127 (May 14,
2024), 89 FR 43969 (May 20, 2024).
\8\ See Securities Exchange Act Release No. 100556 (July 18,
2024), 89 FR 59779 (July 23, 2024).
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This order disapproves the Proposed Amendment.
II. Overview
The Participants adopted the Plan to address extraordinary
volatility in the securities markets, i.e., significant fluctuations in
individual securities' prices over a short period of time, such as
those experienced during the ``Flash Crash'' on the afternoon of May 6,
2010. The Plan sets forth procedures that provide for market-wide limit
up-limit down requirements to prevent trades in individual NMS Stocks
from occurring outside of the specified Price Bands to address
instances of extraordinary volatility in NMS Stocks.\9\ These limit up-
limit down requirements are coupled with Trading Pauses to accommodate
more fundamental price moves.
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\9\ See Notice, 88 FR at 81144-45 (setting forth the defined
terms as used under the Plan). For purposes of this order, all
capitalized terms referenced, but not otherwise defined, herein
shall have the meanings as defined under the Plan or as defined in
the Notice.
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As set forth in more detail in the Plan, the single plan processor,
which is responsible for consolidation of information for an NMS Stock
pursuant to Rule 603(b) of Regulation NMS under the Exchange Act,
calculates and disseminates a lower Price Band and upper Price Band for
each NMS Stock. As set forth in Section V of the Plan, the Price Bands
are based on a Reference Price for each NMS Stock that equals the
arithmetic mean price of Eligible Reported Transactions for the NMS
Stock over the immediately preceding five-minute period. The Price
Bands for an NMS Stock are calculated by applying the Percentage
Parameters, as set out in Appendix A to the Plan,\10\ for such NMS
Stock to the Reference Price, with the lower Price Band being a
Percentage Parameter below the Reference Price, and the upper Price
Band being a Percentage Parameter above the Reference Price.
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\10\ See Notice, 88 FR at 81148 (Appendix A to the Plan).
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Appendix A to the Plan sets out the definitions of Tier 1 and Tier
2 NMS Stocks and the Percentage Parameters for each. Appendix A
currently provides that Tier 1 includes all NMS Stocks included in the
S&P 500 Index and the Russell 1000 Index, as well as ``eligible'' ETPs,
which are ETPs that trade over $2,000,000 notional consolidated average
daily volume (``CADV'') over a period from the first day of the
previous fiscal half year up until one week before the beginning of the
next fiscal half year. Eligible ETPs are listed in Schedule 1 to
Appendix A, and the list is reviewed and updated semi-annually. All
ETPs that do not meet the ``eligibility'' definition are currently
assigned to Tier 2.
For Tier 1 NMS Stocks, Appendix A defines the Percentage Parameters
as:
<bullet> 5% for Tier 1 NMS Stocks with a Reference Price more than
$3.00;
<bullet> 20% for Tier 1 NMS Stocks with a Reference Price equal to
$0.75 and up to and including $3.00; and
<bullet> The lesser of $0.15 or 75% for Tier 1 NMS Stocks with a
Reference Price less than $0.75.
For Tier 2 NMS Stocks, Appendix A defines the Percentage Parameters
as:
<bullet> 10% for Tier 2 NMS Stocks with a Reference Price of more
than $3.00;
<bullet> 20% for Tier 2 NMS Stocks with a Reference Price equal to
$0.75 and up to and including $3.00; and
<bullet> The lesser of $0.15 or 75% for Tier 2 NMS Stocks with a
Reference Price less than $0.75.
Appendix A further provides that the Percentage Parameter for a
Tier 2 NMS Stock that is a leveraged ETP is the applicable Percentage
Parameter set forth above, multiplied by the leverage ratio of such
product.
III. Summary of the Proposed Amendment \11\
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\11\ This section summarizes the proposed changes to the Plan
and the Participants' analysis supporting the proposed changes, as
described in the Notice. The Notice contains the Participants' full
discussion of the Proposed Amendment, including the Participants'
justifications for the Proposed Amendment. See Notice, supra note 4.
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The Participants propose to amend Appendix A to delete the
definition of ETPs ``eligible'' for Tier 1, and to specify that all
ETPs except for single-stock ETPs would be assigned to Tier 1. The
Proposed Amendment would generally result in tighter Price Bands being
applied on Tier 2 ETPs than currently apply. The Participants also
propose to delete Schedule 1 to Appendix A as obsolete. Under the
Proposal, Appendix A, Section I, paragraph (1) would read as follows:
Tier 1 NMS Stocks shall include all NMS Stocks included in the
S&P 500 Index and the Russell 1000 Index, and all exchange-traded
products (``ETP''), except for single stock ETPs, which will be
assigned to the same Tier as their underlying stock, adjusted for
any leverage factor.
Because all leveraged ETPs (except Tier 2 single-stock ETPs) would
be assigned to Tier 1, the Participants also propose to add text into
Section I of Appendix A describing how the Percentage Parameters would
be set for leveraged ETPs. The Participants propose to insert the
following as paragraph (5) of Section I, and to renumber the paragraphs
of Section I accordingly:
Notwithstanding the foregoing, the Percentage Parameters for a
Tier 1 NMS
[[Page 77204]]
Stock that is a leveraged ETP shall be the applicable Percentage
Parameter set forth in clauses (2), (3), or (4) above, multiplied by
the leverage ratio of such product.
At the request of ETP issuers, the Participants conducted a study
concerning the calibration of the Percentage Parameters set forth in
the Plan with respect to ETPs in Tier 2.\12\ The Participants
subsequently conducted additional analysis (``Supplemental Analysis'')
on the narrowing of the Percentage Parameters.\13\ The Participants
reached the following conclusions based on the analysis in the study
and the Supplemental Analysis (collectively ``Analyses''):
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\12\ See Notice, 88 FR at 81133.
\13\ The Participants submitted a letter with the Supplemental
Analysis in support of the Proposed Amendment. See Letter from
Robert Books, Chair, Operating Committee of the Plan, dated June 17,
2024 (``Participants' Letter'').
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<bullet> Tier 1 non-ETPs are far more likely than Tier 2 ETPs to
enter into Limit States and Trading Pauses due to the underlying
volatility of these securities. This finding suggests that the Price
Band width for Tier 2 ETPs is poorly calibrated relative to their
actual trading behavior.\14\ The Supplemental Analysis performed by the
Participants reached the same conclusion using two different
methodologies.\15\
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\14\ See Notice, 88 FR at 81142.
\15\ See Participants' Letter at 3 (``When combined with the
data in the Proposal's Table 2 concerning the incidence of Limit
States and Trading Pauses among Tier 1 non-ETPs and Tier 2 ETPs and
non-ETPs, these additional volatility statistics provide further
support for the Participant's conclusion in the Proposal . . . that
the current Price Bands are not well-calibrated to the realized
volatility for Tier 2 ETPs and should not be twice as wide as those
for Tier 1 non-ETPs.'').
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<bullet> During the period looked at in the study presented in the
Proposed Amendment, the notional value of trades that would have been
prevented if Tier 2 ETPs had used tighter Tier 1 Price Bands would have
been substantial for such thinly traded products, bounded on the lower
end at $36.8 million and the upper end at $711.1 million.\16\
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\16\ See Notice, 88 FR at 81142. See also id. at 81135-36
(explaining how the Participants calculated the upper and lower
ranges of the notional value of trades).
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<bullet> The Participants calculated theoretical Tier 1 (i.e., 5%,
adjusted for the leverage factor) Price Bands for all Tier 2 ETPs in
the study presented in the Proposed Amendment (``Theoretical Tier 1
Bands'').\17\ In this analysis from the study, the Participants
compared the execution price to the midpoint price of the National Best
Bid or Offer (``NBBO'') at five and ten minutes after such execution.
Using this methodology, in the majority of cases where a trade would
have been prevented by the narrower Theoretical Tier 1 Bands, prices
reverted by the end of the following five- and ten-minute periods,
suggesting that having these thinly traded ETPs in Tier 1 would protect
investors from executing trades at inferior prices that may occur due
to transitory gaps in liquidity rather than fundamental valuation
changes.\18\ In the Supplemental Analysis, the Participants used a
different methodology, specifically comparing the midpoint of the NBBO
at five and ten minutes after the trade to the midpoint of the NBBO
\19\ at the time of execution, to demonstrate price movement after
theorical block trades and again reached conclusions they state support
the Proposed Amendment.\20\
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\17\ Id. at 81135.
\18\ Id. at 81142.
\19\ While the Supplemental Analysis stated that it compared the
midpoint of the NBBO at five and ten minutes after the trade to the
midpoint of the quote at the time of execution, in the context of
the analysis performed, the Commission understands that ``quote''
meant the NBBO at the time of execution, given the use of the
midpoint at five and ten minutes in the Supplemental Analysis and
the use of the NBBO midpoint in the Participant's study that was
part of the Proposal.
\20\ See Participants' Letter at 4 (stating that the results of
the Supplemental Analysis show that ``more than 60% of the time,
prices 5 and 10 minutes after a theoretically prevented trade
reverted away from the offending trade price towards prior prices.
Share volume reversion remained above 50% after five minutes and
above 60% after 10 minutes. This tendency toward reversion is
further evidence in support of narrowing the bands to Tier 1-
levels.''). The Participants state they conducted this additional
price reversion analysis to account for concerns with the prior
analysis, which compared the execution prices of Tier 2 ETPs to the
midpoint of the NBBO five and ten minutes after such execution. See
Participants' Letter at 4.
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<bullet> In most cases where ETPs have been reclassified from Tier
2 to Tier 1, market quality improved as evidenced by the lower quote
volatility, tighter spreads, and increased liquidity for ETPs that
moved from Tier 2 to Tier 1.\21\
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\21\ See Notice, 88 FR at 81142.
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<bullet> Using tighter Tier 1 bands for all ETPs would provide
greater investor protection from temporary liquidity gaps, which are
facilitated by the wider Price Bands in Tier 2.\22\
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\22\ Id.
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<bullet> The number of Limit States and Trading Pauses decreased
when Tier 2 ETPs moved to Tier 1, and increased when Tier 1 ETPs moved
to Tier 2.\23\
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\23\ Id.
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Based on these conclusions, the Participants state that they
believe that moving Tier 2 ETPs to Tier 1 would improve market quality,
more effectively dampen volatility, decrease the number of unnecessary
Limit States and Trading Pauses, and thereby provide greater investor
protection.\24\
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\24\ See Notice, 88 FR at 81142. See also Participants' Letter
at 6.
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IV. Discussion
A. The Applicable Standard of Review
Under Rule 608(b)(2) of Regulation NMS, the Commission shall
approve a national market system plan or proposed amendment to an
effective national market system plan, with such changes or subject to
such conditions as the Commission may deem necessary or appropriate, if
it finds that such plan or amendment is necessary or appropriate in the
public interest, for the protection of investors and the maintenance of
fair and orderly markets, to remove impediments to, and perfect the
mechanisms of, a national market system, or otherwise in furtherance of
the purposes of the Exchange Act.\25\ Under Rule 700(b)(3)(ii) of the
Commission's Rules of Practice, the ``burden to demonstrate that a NMS
plan filing is consistent with the Exchange Act and the rules and
regulations issued thereunder that are applicable to NMS plans is on
the plan participants that filed the NMS plan filing.'' \26\ The
Commission shall disapprove a national market system plan or proposed
amendment if it does not make such a finding.\27\
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\25\ 17 CFR 242.608(b)(2).
\26\ 17 CFR 201.700(b)(3)(ii). In addition, Rule 700(b)(3)(ii)
of the Commission's Rules of Practice states that ``[a]ny failure of
the plan participants that filed the NMS plan filing to provide such
detail and specificity may result in the Commission not having a
sufficient basis to make an affirmative finding that a NMS plan
filing is consistent with the Exchange Act and the rules and
regulations issued thereunder that are applicable to NMS plans.''
Id.
\27\ 17 CFR 242.608(b)(2). Approval or disapproval of a national
market system plan, or an amendment to an effective national market
system plan (other than an amendment initiated by the Commission),
shall be by order. Id.
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For the reasons described below, the Participants have not
demonstrated that the Proposal meets the standard under Rule 608(b)(2)
of Regulation NMS. As such, the Commission is disapproving the Proposed
Amendment because it cannot make the finding that the Proposed
Amendment is necessary or appropriate in the public interest, for the
protection of investors and the maintenance of fair and orderly
markets, to remove impediments to, and perfect the mechanisms of, a
national market system, or otherwise in furtherance of the purposes of
the Exchange Act.\28\
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\28\ 17 CFR 242.608(b)(2).
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[[Page 77205]]
B. Comments Received
Certain commenters express support for the Proposed Amendment.\29\
One commenter states that it is important to maintain the leverage
factor adjustment when moving leveraged ETPs into Tier 1.\30\ Another
commenter, writing on behalf of a ``diverse cross-section of market
participants,'' states that using Tier 1 Percentage Parameters for all
ETPs would better protect investors during temporary liquidity
gaps.\31\ The commenter states that the risk of an inefficient
execution away from the fair value of the ETP's holdings (as far as 10%
away from a Tier 2 ETP's Reference Price) rises in the case of a
liquidity gap resulting from an outsized or aggressive order, temporary
uncertainty about any inputs into the calculation of the ETP's fair
value, or lower levels of market participation.\32\ This commenter also
states that the application of Tier 1 Percentage Parameters may enhance
investor protection, provide a better ETP execution experience for
market participants, and would improve transparency and efficiency,
particularly during periods of extreme volatility.\33\ Another
commenter states that the Participants' data presented in the Proposed
Amendment showed that while narrow Price Bands resulted in more trading
halts in the time period studied, had narrower Price Bands been in
place for ETPs during periods of extreme volatility, retail investor
executions at inferior prices would likely have been prevented.\34\
Some commenters that support the proposal state that ETPs are assigned
to tiers based on an assumption that lower-volume ETPs are more suited
for wider Price Parameters, and state that the data presented in the
Proposed Amendment suggest that this assumption was wrong.\35\ Some
commenters that support the Proposal state that the analysis from the
study in the Proposed Amendment demonstrated that on average, Tier 2
ETPs across asset classes exhibit lower quote volatility than Tier 1
non-ETP stocks.\36\ In light of the findings derived from the study,
some commenters state that the imposed semi-annual migration of ETPs
from one tier to the other appears to be overly complex, arbitrary, and
unnecessary.\37\ One commenter states that there is no reason to expect
the Tier 1 Price Band is inappropriate for Tier 2 ETPs that are based
on a single reference asset, stating that approximately 33% of single
asset commodity based ETPs representing a wide range of commodity types
are Tier 1 securities.\38\
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\29\ See Letters from Samara Cohen, Chief Investment Officer of
ETF and Index Investments, BlackRock, et al., dated Dec. 18, 2023
(``BlackRock Letter''); Kenneth Fang, Associate General Counsel, and
Kevin Ercoline, Assistant General Counsel, Investment Company
Institute, dated Mar. 14, 2024 (``ICI Letter'') (expressing support
for the comments made in the BlackRock Letter); Ellen Greene,
Managing Director, Equities & Options Market Structure, Securities
Industry and Financial Markets Association (``SIFMA'') and Kevin
Ehrlich, Managing Director, SIFMA Asset Management Group, dated Apr.
22, 2024 (``SIFMA Letter'').
\30\ See ICI Letter at 4. See also SIFMA Letter at 3 (stating
that multiplying the Tier 1 Percentage Parameters by an ETP's
leverage ratio, as proposed, would address potential volatility in
these products).
\31\ See BlackRock Letter at 1.
\32\ Id. at 2.
\33\ See id. at 1-2. Some commenters state that, in instances of
sustained order imbalances and/or gaps in liquidity in the market
for an ETP, a trading pause would help attract liquidity from
diverse market participants and promote price discovery through the
reopening mechanism, helping to keep ETP prices in line with the
value of underlying holdings. See BlackRock Letter at 2. See also
ICI Letter at 3 (stating that during periods of extreme volatility
and transitory gaps in liquidity, it may be beneficial for a trading
pause to be triggered); SIFMA Letter at 2.
\34\ See ICI Letter at 3.
\35\ See BlackRock Letter at 2. See also ICI Letter at 4
(stating that the Participants' data demonstrate that an assumption
that lower-volume ETPs were more suited for wider Price Bands was
not accurate).
\36\ See BlackRock Letter at 2. See also ICI Letter at 4
(stating Tier 2 ETPs on average exhibit lower quote volatility than
Tier 1 non-ETP stocks); SIFMA Letter at 2-3 (stating that the
Participants' study showed that ETPs assigned to Tier 2 had quote
volatilities lower than both Tier 1 ETPs and Tier 2 non-ETPs).
\37\ See BlackRock Letter at 2. See also SIFMA Letter at 4
(stating that approval of the Proposed Amendment ``would benefit
investors by reducing complexity and enhancing fair and orderly
markets for trading ETPs'').
\38\ See SIFMA Letter at 3 (stating additionally that several
ETPs consisting of currency products are also assigned to Tier 1).
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Some commenters oppose the Proposed Amendment,\39\ with some
commenters stating that the proposed tighter Price Bands would
effectively limit the natural price discovery process, which would
infringe upon free market principles \40\ and may lead to increased
volatility.\41\ One commenter further states that leveraged
derivatives, such as options and futures, allow significant positions
to be taken with relatively less capital.\42\ The same commenter states
that the Proposal caters to the interests of larger, institutional
investors who may benefit from reduced volatility and more predictable
price movements at the expense of smaller, retail investors.\43\ Some
commenters state that the Proposal enables the Participants to control
the price of a security inappropriately.\44\
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\39\ See, e.g., Letters from Alexander Kuchta dated Nov. 27,
2023 (``Kuchta Letter''); Rax Nahali dated Nov. 27, 2023 (``Nahali
Letter''); and Rene Wright dated Nov. 27, 2023 (``Wright Letter'').
\40\ See Kuchta Letter. See also Joe Edwards dated Nov. 27, 2023
(``Edwards Letter'') (stating that ``[t]his rule goes against the
ideals of a free and fair market''); Nahali Letter (stating that
``[i]f the markets are as free and fair as the SEC suggests they
are, there is no need for this rule to be in place'').
\41\ See Kuchta Letter (stating that ``as trades accumulate at
the band limits, the resumption of trading could trigger sudden and
sharp price movements, contrary to the proposal's intent to reduce
volatility'').
\42\ See id.
\43\ See id.
\44\ See Mazundar Letter. See also Nahali Letter (stating the
rule ``would allow the exchanges to collude and set prices where
they want them.'').
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C. Participants' Findings and Commission Response
The Commission approved the Plan in 2012 on a pilot basis,
recognizing that after the Participants and the public gain experience
with the operations of the Plan, modifications may be necessary or
appropriate.\45\ At the time the Commission permanently approved the
Plan in 2019, the Commission recognized that robust, data-driven
assessments of the Plan's effectiveness are important to ensure that
the Plan remains designed to achieve its objective,\46\ and the
Commission supports continuing efforts to improve the operation of the
Plan consistent with Rule 608 of Regulation NMS under the Exchange
Act.\47\
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\45\ See Securities Exchange Act Release No. 67091 (May 31,
2012), 77 FR 33498, 33510 (June 6, 2012) (``LULD Plan Approval
Order'').
\46\ See Securities Exchange Act Release No. 85623 (Apr. 11,
2019), 84 FR 16086, 16090 (Apr. 17, 2019).
\47\ 17 CFR 242.608.
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The Participants state that assigning all ETPs, except for single
stock ETPs, to Tier 1 would improve market quality, more effectively
dampen volatility, provide greater investor protection, and decrease
the number of unnecessary Limit States and Trading Pauses for Tier 2
ETPs.\48\ For these reasons, the Participants state that the Proposed
Amendment is consistent with Rule
[[Page 77206]]
608(b)(2). As discussed in detail below, the Participants have not
carried their burden of demonstrating why the Proposed Amendment is
consistent with Rule 608 of Regulation NMS.
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\48\ See Notice, 88 FR at 81141. The Participants state that
when ETPs moved from Tier 2 to Tier 1 there was an improvement in
market quality and a decrease in the number of Trading Pauses, Limit
States, or the amount of time spent in Limit States, as compared
with ETPs that remained in Tier 2 during the period studied by the
Participants. The Participants state that this is likely because
market participants will change their behavior and provide more
liquidity to ETPs if the bands are tightened. The Participants also
state that market participants adjusted to tighter Price Bands after
Amendment 18 to the Plan narrowed the Price Bands near the open and
close of trading. However, the Participants state that this analysis
concerning Trading Pauses and Limit States may not offer strong
support for its conclusions given the relatively small number of
ETPs that move between Tier 1 and Tier 2 designations; further, the
Participants state that, ``in some cases, changes in the volume of
trades are what cause an ETP to change from one tier to another, and
the improvements in market quality may be attributable to that
increased volume, and not the tier change in and of itself.'' Id.
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In the Proposal, the Participants state that, except for single-
stock, commodity, and foreign exchange-based ETPs, ETPs are diversified
instruments and that the analysis in the Proposal supports the modern
portfolio theory that portfolios of securities exhibit lower volatility
than individual securities, unless those products are perfectly
correlated. At the same time, the Participants acknowledge that the
ETPs studied cover several asset classes, including domestic equities,
international equities, fixed income, currency, commodity, and digital
currency ETPs.\49\ The Participants' Analyses, however, provide
aggregate statistical information with respect to all Tier 2 ETPs
despite securities within this group having different trading
characteristics. These Analyses and the resulting aggregate statistical
information concern the volatility characteristics of Tier 2 ETPs and
the potential costs (i.e., trading activity disruption) and benefits
(i.e., protecting investors from trading at inferior prices that may
occur because of transitory gaps in liquidity rather than fundamental
value changes; market quality improvement) of designating all Tier 2
ETPs as Tier 1 securities. The Commission is concerned that these
aggregate statistical analyses for Tier 2 ETPs do not reflect the
trading characteristics and potential effects of the Proposed Amendment
for many Tier 2 ETPs.
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\49\ Id. at 81134.
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According to the Annual Report for 2023 by the Operating Committee
of the Plan, in 2023 there were over two thousand ETPs designated as
Tier 2 securities.\50\ While the Proposed Amendment would exclude
single stock ETPs from automatically being designated as Tier 1
securities,\51\ the Proposal would not exclude other Tier 2 ETPs,
including those based on other single reference assets,\52\ that may
exhibit substantially different trading characteristics than those
reflected in the Proposal's aggregate statistical analysis concerning
the over two thousand Tier 2 ETPs or otherwise provide data
demonstrating why these Tier 2 ETPs would be appropriately designated
as Tier 1 securities regardless of their different trading
characteristics. The above-mentioned issues were raised by the
Commission in the Notice and OIP.\53\
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\50\ See Annual Report for 2023 of the Operating Committee of
the Plan to Address Extraordinary Market Volatility, May 3, 2024
(available at <a href="https://www.luldplan.com/studies">https://www.luldplan.com/studies</a>).
\51\ The Participants state that the purpose of having different
LULD tiers is to assign Price Bands that are commensurate with a
security's underlying volatility and that single stock ETPs should
be assigned to the same LULD tier as the underlying security because
the ETP should closely track the price movement and volatility of
its underlying security. See Notice, 88 FR at 81133.
\52\ With respect to the comment that there are many single
reference asset ETPs that currently are Tier 1 securities, those
securities are designated as Tier 1 securities because their CADV
meets the standard set forth in the Plan for ETPs that are
designated as Tier 1 securities. See supra note 3838 38and
accompanying text. The fact that some single reference asset ETPs
may be appropriately characterized as Tier 1 securities under the
Plan does not demonstrate that all single reference asset ETPs would
be appropriately designated as Tier 1 securities because different
single reference asset ETPs may have different trading
characteristics that result in them being appropriately categorized
as Tier 2 securities. The Participants' Analyses do not provide
sufficient detail and specificity concerning these securities for
the Commission to make an affirmative finding that the Proposed
Amendment meets the standard for approval. See 17 CFR
201.700(b)(3)(ii). See also infra note 56.
\53\ See Notice, 88 FR at 81143 and OIP, 89 FR at 13394.
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For example, key elements of the Analyses aggregate all trades of
Tier 2 ETPs together.\54\ Such a method will effectively ignore Tier 2
ETPs that trade infrequently--this is because any analysis that uses
aggregate trading statistics will be driven by the ETPs with a high
level of trading activity, while ETPs with a low level of trading will
have a low weight in the statistical analysis. This result is
compounded by combining leveraged and non-leveraged Tier 2 ETPs in the
same group because trading activity among Tier 2 ETPs is highly skewed
by leveraged ETPs. All leveraged ETPs are in Tier 2 regardless of their
trading volume, and some have a high level of volume.\55\ In contrast,
a non-leveraged ETP is only in Tier 2 if it has less than $2 million
CADV per day over the past six months. This implies that an aggregate
analysis of all Tier 2 ETP trades will be driven by a relatively small
number of high-volume leveraged ETPs, and such analysis will
effectively ignore the vast majority of Tier 2 ETPs.\56\ Because
elements of the Analyses are driven by a small number of high-volume
leveraged ETPs, it is not appropriate to extend the conclusions from
the Analyses to the nearly 2,000 non-leveraged Tier 2 ETPs with
substantially less volume; therefore, key analyses--such as the
analysis of price dynamics around the Price Bands--do not support
moving all 2,000 Tier 2 ETPs into Tier 1. A more granular statistical
analysis could show that, for certain ETPs that are currently in Tier
2, the move to Tier 1 and resultant narrower Price Bands would result
in excessive Straddle States, Limit States and Trading Pauses that are
not due to extraordinary volatility caused by transitory gaps in
liquidity, which these measures are designed to mitigate, but instead
would unduly interrupt trading activity driven by fundamental value
changes. For this reason, the Participants' Analyses do not provide
sufficient detail and specificity concerning these securities for the
Commission to make an affirmative finding that the Proposed Amendment
meets the standard for approval.\57\
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\54\ In the analysis in the Proposed Amendment, Table 3, 4, 5,
and Chart 1 aggregate all Tier 2 ETP trades into a single group;
Table B of the Supplemental Analysis does likewise. These tables
quantify the amount of volume that would be affected by tighter
bands, and the price dynamics around the tighter bands.
\55\ For example, in the second half of 2023, TQQQ, SQQQ, and
SOXL averaged daily volume in excess of $1 billion; these are all
ETPs with a leverage ratio of three. The 20 Tier 2 ETPs with the
highest dollar volume each averaged over $100 million per day during
this period. For this analysis, a stock's tier is assigned based on
FINRA's OTC Transparency Data, <a href="http://www.finra.org/industry/OTC-Transparency">http://www.finra.org/industry/OTC-Transparency</a>, which classifies stocks by tier on a weekly basis. A
stock is considered an ETP if its security description in the TAQ
database is `ETF,' `ETN,' or `ETV.' The TAQ database also contains
information on the ETPs' Price Bands, which the Commission uses to
infer the ETPs' leveraged ratios (e.g., a Price Band of 30% during
the day implies that the ETP has a leverage ratio of three).
Finally, trading volume for each stock comes from WRDS intra-day
indicators.
\56\ The OIP raised the issue that an aggregated approach to
evaluating Tier 2 ETPs may not support moving all Tier 2 ETPs into
Tier 1. See OIP, 89 FR at 13394. In response, the Participants
provided a disaggregated analysis of commodity ETPs in the
Supplemental Analysis that they believe shows that commodity ETPs
should not be excluded from Tier 1 designation under the Proposed
Amendment because they have similar characteristics to ETPs already
in Tier 1; however, this disaggregated analysis contained only 65
Tier 2 ETPs. See Participants' Letter at 4-6. This disaggregated
analysis does not sufficiently address the Commission's concerns
because it does not provide insight as to whether it is appropriate
to move other Tier 2 ETPs to Tier 1. Commission analysis indicates
that, in the second half of 2023, the 20 Tier 2 ETPs with the
highest share volume comprised 80% of all share volume among Tier 2
ETPs. Those same ETPs account for 74% of all Tier 2 ETP dollar
volume, and 76% of all Tier 2 ETP trade volume. This implies that
the trade-weighted aggregated analysis in the Proposed Amendment
(see supra note 54) was likely driven by approximately 20 out of the
2,000 Tier 2 ETPs; separately analyzing 65 Tier 2 ETPs still
overlooks the vast majority of Tier 2 ETPs.
\57\ See 17 CFR 242.608(b)(2). See also 17 CFR
201.700(b)(3)(ii).
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In addition to the issues discussed above, in the Notice and OIP
the Commission addressed potential issues with respect to the
Participants' statements regarding the Proposed Amendment's benefits
and analysis concerning the volatility characteristics of Tier 2 ETPs
as compared to Tier 1
[[Page 77207]]
securities that are not ETPs.\58\ The Participants state that the
Proposed Amendment would protect investors from executing trades at
inferior prices that may occur due to transitory gaps in liquidity
rather than fundamental valuation,\59\ and some commenters state their
support for this element of the Proposal's analysis.\60\ However, as
discussed further below, the study presented in the Proposed Amendment
and the Supplemental Analysis supporting this investor protection
benefit are not robust or compelling. The Participants rely on the
Analyses, which documented price reversion after Theoretical Tier 1
Bands had been breached in Tier 2 ETPs, as evidence that investors
transacted at inferior prices and would have benefited from tighter
Price Bands.\61\
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\58\ See Notice, 88 FR at 81143 and OIP, 89 FR at 13395.
\59\ See Notice, 88 FR at 81137-38.
\60\ See supra notes 31-33 and accompanying text.
\61\ See Notice, 88 FR at 81137; Participants' Letter at 4.
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There are three concerns with the price reversion analysis provided
in the study presented in the Proposed Amendment and the Supplemental
Analysis. First, as stated above, the price reversion analyses in the
study in the Proposed Amendment and Supplemental Analysis are done on
an aggregate basis for all Tier 2 ETPs. Many Tier 2 ETPs may show
different price reversion results than reflected in the Analyses.
Second, the conclusions from the study's price reversion analysis are
not robust because that price reversion analysis compared trade prices
that occurred outside of the Theoretical Tier 1 Bands to subsequent
midpoint prices. This methodology is flawed because by comparing the
execution price to a subsequent midpoint price, the methodology could
incorrectly identify a price reversion--which is cited as evidence of
inferior trades--even if nothing else changes with respect to the
security (e.g., fundamental value, bid and ask prices stay constant) or
even if the midpoint price continues to move in the same direction.\62\
The Commission requested comment concerning the analysis included with
the Proposal in the Notice and OIP,\63\ and the Participants performed
a Supplemental Analysis to address concerns that the Proposal's
analysis could overestimate the degree of price reversion.\64\ In
particular, the Participants performed a price reversion analysis that
compared the midpoint of the NBBO at five and ten minutes after the
trade to the midpoint of the NBBO at the time of execution.\65\ While
this methodology in the Supplemental Analysis \66\ is more robust than
the methodology of the study included in the Proposed Amendment, it
also showed a decrease in the amount of price reversion experienced by
Tier 2 ETPs. This raises a third concern. In particular, the additional
price reversion analysis reflects some reversion metrics dropping from
74% in the Proposal to 52% in the Supplemental Analysis. Given that
prices fluctuate unpredictably over such short horizons, prices should
revert 50% of the time and continue in the same direction 50% of the
time; therefore, this estimated reversion probability of 52% in the
Supplemental Analysis is little better than chance and does not support
the Participants' statement that investors would have been protected by
the tighter band.\67\ The reduction in the estimated amount of price
reversion also increases the likelihood that some individual Tier 2
ETPs experience price continuation--rather than reversion--near the
Theoretical Tier 1 Bands, but this possibility cannot be detected when
all two thousand Tier 2 ETPs are included in the aggregate statistical
analysis.
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\62\ For example, consider a trade that crosses below the lower
Theoretical Tier 1 Band. It is likely that this trade executed at
the bid (because the bid price is lower than the ask). Assume the
bid is at $9 and the ask is at $11. If there is no price reversion--
that is, the bid ($9) and ask ($11) stay the same after this trade--
then the subsequent midpoint price ($10) would be higher than the
trade price ($9), resulting in the methodology incorrectly
identifying this as a price reversion. It is also possible that
prices exhibited continuation--that is, prices continued to fall--
but the subsequent midpoint did not fall below the original bid.
Both of these cases would incorrectly be coded as a ``price
reversion'' in the Proposal's analysis; the Proposal's analysis
therefore appears to overestimate the degree of price reversion.
\63\ See Notice, 88 FR at 81143 and OIP, 89 FR at 13394-95.
\64\ See Participants' Letter at 4.
\65\ Id.
\66\ Id.
\67\ The Supplemental Analysis shows higher reversion when
measured as a fraction of trades, which implies that trades with a
low number of shares are more likely to revert. This analysis does
not calculate reversion on a dollar-weighted basis, so it is unclear
what fraction of dollars may have been executed during a transitory
gap in liquidity.
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The Participants also state that Tier 2 ETPs are less volatile than
Tier 1 non-ETP securities, and that this lesser volatility is evidence
that the current Price Bands for Tier 2 ETPs are poorly calibrated.\68\
Some commenters supported this element of the Proposal's analysis.\69\
However, that volatility analysis is also flawed.\70\ First, as
discussed above, the Participants' Analyses are insufficiently granular
as they combine nearly two thousand non-leveraged Tier 2 ETPs into a
single group and compare them to all Tier 1 non-ETPs. Yet there may be
many non-leveraged Tier 2 ETPs that reflect substantially different
trading characteristics, and the Participants' Analyses do not provide
sufficient detail and specificity concerning these securities for the
Commission to make an affirmative finding that the Proposed Amendment
meets the standard for approval.\71\
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\68\ See Notice, 88 FR at 81134-37.
\69\ See supra notes 34-36 and accompanying text.
\70\ See Notice, 88 FR at 81143 and OIP, 89 FR at 13395.
\71\ See 17 CFR 242.608(b)(2). See also 17 CFR
201.700(b)(3)(ii).
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Some non-leveraged Tier 2 ETPs--due to their relatively low trading
volume--may experience trades that are spread out over time. When the
time between trades is longer, the amount of new information in the
market since the last trade will generally be higher, resulting in
greater price changes--i.e., greater volatility--from trade-to-
trade.\72\ A tighter Price Band for these securities will be likely to
inhibit this new information from being incorporated into trade prices
and the Participants' Analyses do not address this possibility and its
potential impact.\73\ Second, volatility is an imprecise metric for
determining Price Bands. This is because volatility is averaged over
many days and many stocks, while the Price Bands are meant to curb
extraordinary volatility (e.g., the velocity of significant price
moves).\74\ Average levels of volatility, therefore, are a coarse
metric in determining whether a stock can sustain tighter Price
Bands.\75\ Third, the
[[Page 77208]]
Proposal's analysis measured volatility using changes in the midpoint
price of Tier 2 ETPs from second-to-second. This method of analysis is
not robust for studying the volatility of securities that trade
infrequently or have low quoting activity because the estimated
volatility will be biased toward zero for these securities.\76\ As part
of the Supplemental Analysis the Participants provided a new analysis
of the volatility Tier 2 ETPs.\77\ While this analysis uses a more
robust method for evaluating the volatility of Tier 2 ETPs as compared
to Tier 1 non-ETPs, it presents the same concerns discussed above. In
particular, it is an insufficiently granular statistical analysis of
all Tier 2 ETP volatility, and there may be many Tier 2 ETPs that
exhibit different trading characteristics, which the Analyses do not
take into consideration. This possibility is evident in the
distributional statistics in the Supplemental Analysis: the average
quote volatilities for Tier 2 ETPs (both leveraged and non-leveraged)
are multiples of the median quote volatilities, implying that the
distribution is skewed by observations with volatility far higher than
the average. Tier 1 ETPs exhibit less evidence of skewness. Therefore,
the supplemental volatility analysis does not support moving all Tier 2
ETPs into Tier 1.
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\72\ Changes in stock valuations are often modelled as a
``random walk.'' In such a model, the stock's value moves randomly
at successive steps; as the number of steps increases, the
dispersion in the stock's value also increases (i.e., the change in
stock value is more volatile when it is measured over a longer
horizon (because there are more steps as the horizon increases)).
When a stock trades relatively infrequently, there are more such
steps between trades, which generates greater volatility from one
trade to the next.
\73\ As discussed in the previous paragraph, many Tier 2 ETPs
may show different price reversion results than reflected in the
aggregate statistical analysis. For example, when a stock's trades
are spread out over time, it will experience greater price changes
trade-to-trade due to the greater amount of information between
trades; such price changes will be less likely to revert after
crossing the Theoretical Tier 1 Bands because the price change is
driven by new information rather than a temporary liquidity gap.
\74\ See LULD Plan Approval Order, 77 FR at 33508-33510. As the
participants' analysis shows in Table 2 of the Proposed Amendment,
limit states and trading pauses are rare events.
\75\ The methodology studying theoretical blocked trades more
precisely captures the relevant periods of extraordinary volatility
because this method includes only relatively rare events in which
prices move several percentage points within a short time period.
But, as discussed previously, this analysis was aggregated in a way
that makes its results impossible to generalize to the typical Tier
2 ETP.
\76\ For example, consider two ETPs with the same fundamental
volatility but different levels of trading activity. Suppose the
first ETP is traded frequently with quote updates every second; it
therefore has 23,400 second-to-second returns during the trading day
(sixty updates per minute for 6.5 hours). Suppose that the second
ETP only receives a quote update once per minute; it will have 390
second-to-second returns, and 23,010 seconds with an unchanged
midpoint (i.e., a return of 0). The Proposal's methodology is likely
to estimate a substantially lower volatility for the second ETP due
to the fact that the vast majority of observations are coded as a 0.
Using the NBBO files in the TAQ database for the second half of
2023, the Commission estimates that the median non-leveraged Tier 2
ETP receives approximately 2,900 NBBO updates per day; this implies
that the second-to-second volatility calculation for the median Tier
2 ETP will use at least 20,500 seconds with a return of 0 due to a
lack of data (23,400 seconds per day, less the 2,900 NBBO updates).
In contrast, the median Tier 1 security receives over 23,400 NBBO
updates per day. It is likely therefore that the Proposal's
methodology underestimates the volatility of non-leveraged Tier 2
ETPs due to the prevalence of missing returns. The Participants
disagreed with this assessment of their methodology, stating that
``quotes for even thinly-traded ETPs change frequently as market
makers update their valuations of ETPs' underlying portfolios, so it
is not the case that the computation of quote volatility is biased
by many zeroes.'' See Participants' Letter at 2. The Participants
did not provide any evidence to support this statement.
\77\ See Participants' Letter at 2-4.
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Accordingly, based on the study in the Proposal and the
Supplemental Analysis and for the reasons discussed throughout this
order, the Commission cannot find that designating over two thousand
ETPs as Tier 1 securities and subjecting them to tighter Price Bands is
necessary or appropriate in the public interest, for the protection of
investors and the maintenance of fair and orderly markets, to remove
impediments to, and perfect the mechanisms of, a national market
system, or otherwise in furtherance of the purposes of the Act, as
required for approval of a plan amendment pursuant to Rule 608(b)(2).
Designating Tier 2 ETPs as Tier 1 securities based on an aggregate
statistical analysis could result in excessive Straddle States, Limit
States and Trading Pauses in certain affected ETPs due to tighter Price
Bands, and thus unduly impede trading in many securities for market
participants that trade in these securities.
V. Conclusion
For the reasons set forth above, the Commission does not find,
pursuant to Section 11A of the Act,\78\ and Rule 608(b)(2)
thereunder,\79\ that the Proposed Amendment is necessary or appropriate
in the public interest, for the protection of investors and the
maintenance of fair and orderly markets, to remove impediments to, and
perfect the mechanisms of, a national market system, or otherwise in
furtherance of the purposes of the Act.
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\78\ 15 U.S.C. 78k-1.
\79\ 17 CFR 242.608(b)(2).
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It is therefore ordered, pursuant to Section 11A of the Act, and
Rule 608(b)(2) thereunder, that the Proposed Amendment (File No. 4-631)
be, and it hereby is, disapproved.
By the Commission.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2024-21508 Filed 9-19-24; 8:45 am]
BILLING CODE 8011-01-P
</pre></body>
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