Staff Legal Bulletin No. 8 (MR)Action: Publication of Division of Market Regulation Staff Legal Bulletin
Date: September 9, 1998
Summary: This staff legal bulletin sets forth the views of the Division of Market Regulation ("Division") about how broker-dealers should handle customer orders and notify customers when marketwide circuit breakers halt trading on exchanges. This bulletin also states the Division's views about the need for broker-dealers to maintain enough internal systems capacity to operate properly when trading volume is extremely high.
Supplementary Information: The statements in this legal bulletin represent the views of the Division's staff. This bulletin is not a rule, regulation, or statement of the Securities and Exchange Commission. Further, the Commission has not approved or disapproved its contents.
Contact Person: For further information about order handling and circuit breaker issues, contact Alton Harvey at (202) 942-4167. For further information about technological capacity issues, contact Sheila Slevin at (202) 942-0796.
I. Problems That Arose During Trading on October 27 and 28, 1997On October 27 and 28, 1997, the nation's securities markets fell by a record absolute amount on then-record trading volume. 1 In reconstructing the events of October 27 and 28, the Commission staff became aware that a number of broker-dealers and their customers faced significant problems trading on those days. On October 27, the first day that cross-market circuit breakers had ever been triggered, some broker-dealers were apparently confused about how to properly execute retail market orders. On the next day, October 28, historically high trading volume overwhelmed the capacity of some broker-dealer systems, causing those broker-dealers to fail to receive or execute customer orders in a timely manner.
This legal bulletin is intended to provide broker-dealers with guidance on how to handle orders and notify customers should circuit breakers close the markets in the future. This bulletin also is intended to remind broker-dealers that they need to have sufficient internal systems capacity to provide for continuous operation during episodic surges in trading volume.
II. Broker-Dealers Should Handle Circuit Breaker Trading Halts the Same Way That They Handle Other Regulatory Trading HaltsTwo circuit breakers halted trading on October 27, 1997. The first circuit breaker stopped trading for 30 minutes between 2:36 and 3:06 p.m. The second circuit breaker closed the markets for the day at 3:30 p.m. A number of broker-dealers reportedly had problems determining how to properly route retail orders they received following the market's early close. Those firms were uncertain as to whether they should hold the orders for execution at the next day's opening, execute the orders at the last reported price, or cancel the orders. It appears that most firms held those customer orders for execution at the next day's market opening.
A. The Basic Rule Follow Practices Used During Other Regulatory HaltsThe Division believes that on the rare occasions when circuit breakers halt trading,2 broker-dealers should handle pending orders and new orders in the same manner they handle orders for a security in which a self-regulatory organization ("SRO") has imposed a regulatory trading halt. For example, if an issuer is about to release material corporate news during a trading session, the SRO that serves as the primary market for the issuer's securities (i.e., a securities exchange or Nasdaq) would impose a regulatory trading halt (for "news pending") that is honored by all of the other SROs until the news is disseminated and the halt is lifted. SROs impose these types of regulatory trading halts virtually on a daily basis. It is not uncommon for some of these halts to remain in effect through the remainder of the trading session. Broker-dealers and the markets already know how to handle orders when trading in an individual stock is halted, and there is no reason to adopt different practices for circuit breaker halts.
Accordingly, during intraday circuit breaker trading halts, broker-dealers should send pending orders and new orders to a market for execution upon the resumption of trading, unless they receive instructions to the contrary from their customers during the halt.
If circuit breakers close the markets early for the day, broker-dealers should handle pending and new orders in a similar manner. In particular:
B. After-Hours and Pre-Opening TradingThe rules that govern circuit breakers on the stock exchanges are SRO rules, not Commission rules. Accordingly, the SROs have the latitude to make interpretations about the circuit breaker rules, including interpretations about whether members can engage in after-hours or pre-opening trading after circuit breakers have closed the markets early. For example, the New York Stock Exchange currently interprets NYSE Rule 80B, which governs circuit breaker trading halts, as barring members from engaging in trading in NYSE-listed securities prior to the next day's opening when a circuit breaker trading halt has closed the market early for the day.
In the case of over-the-counter securities, the National Association of Securities Dealers ("NASD") has no circuit breaker rule per se. The NASD instead has stated that it would halt trading on Nasdaq upon the Commission's request when other markets have halted trading due to extraordinary market conditions. In response, the Commission has made a standing request that the NASD halt trading whenever circuit breakers have stopped trading on the exchanges.6 After the NASD halted trading on Nasdaq on October 27, the NASD asked the Division to clarify whether the Commission's standing request prevented trading by NASD members prior to the next day's opening. The Division in response agreed with the NASD that it appeared reasonable to permit pre-opening trading starting at 8:00 a.m. on October 28, to assist the price-discovery process. In future instances when late-day circuit breakers stop trading early, the Division would consult with the NASD and evaluate market circumstances prior to determining whether pre-opening trading should be permitted on the next day. In general, however, the Division believes that allowing pre-opening trading is appropriate when late-day circuit breakers stop trading early.
C. Broker-Dealers Should Take Steps to Notify Customers About Order TreatmentWhen circuit breakers have closed the markets, it is likely that customers will try to reach their broker-dealers to determine how their orders will be treated. Ideally, broker-dealers should be prepared to receive telephone calls and other direct communications from customers and to inform them of how pending orders and new orders will be handled. The Division recognizes that direct communications might not always be feasible under those conditions, especially during a brief intraday trading halt. At a minimum, however, broker-dealers (both online and full-service) that maintain a web page should promptly post a notice stating that circuit breaker halts have closed the markets and explaining how pending or new orders will be handled. Moreover, the Division believes that broker-dealers that handle orders through the Internet should have mechanisms in place so that, when a customer attempts to transmit an order after the triggering of a circuit breaker, an electronic response will indicate that the markets are closed and explain how pending orders and new orders will be handled. 7
III. Broker-Dealers Need to Have Enough Systems Capacity to Ensure a High Degree of Operational CapabilityThe Commission received several complaints from customers regarding broker-dealer operations during the heavy trading volume effected on October 27 and 28. In particular, customers complained about receiving poor or untimely executions from broker-dealers. Customers of online broker-dealers also complained about delays in accessing their online brokerage accounts. Because of those problems, some broker-dealers made substantial adjustments to customer accounts.
Because broker-dealers are becoming increasingly reliant on technology to perform trading functions and to route customer orders to markets, these problems could be more severe during future periods of high trading volume. Broker-dealers therefore need to take steps to prevent their operational systems from being overwhelmed by periodic spikes in systems message traffic due to high volume. In particular, broker-dealers should not merely have sufficient systems capacity to handle average-to-heavy loads. Rather, broker-dealers should have the systems capacity to handle exceptional loads of several times the average trading volume.8
A. Access Problems Faced by Customers of Online Broker-DealersNumerous customers of online broker-dealers were unable to gain timely access to their accounts on October 28. Because the Internet contains multiple potential choke points that can slow the flow of information, it is difficult to determine what caused the delays faced by online users attempting to request information or place orders electronically. Moreover, some of the delays faced by online broker-dealers and their customers reflected the existing limitations of the Internet. Overall Internet traffic was extremely heavy on October 28, causing widespread slowness. Also, problems with regional Internet service providers ("ISPs") meant that investors in some areas of the country faced greater delays than investors in other areas of the country.
On the other hand, some of the problems that online investors experienced stemmed from broker-dealers' online systems and their websites. One significant problem was that some broker-dealers' web servers had reached their maximum capacity to handle simultaneous users. Not only did an extraordinarily high number of online investors access broker-dealer web sites on October 28, but they tended to stay connected for longer periods of time than typical. Delays with third-party vendor services and excessive non-customer requests for financial information may also have contributed to the problems. Other potential difficulties with online broker-dealers' web sites included poor distribution of demand across system resources (load balancing), slow access equipment, slow web server software, and poor integration with back-end databases.
Some online broker-dealers also faced other access problems, including broker-dealer telephone lines that were overwhelmed with callers who were frustrated by the inability to access information online.
B. Execution Problems Faced by Broker-DealersSome broker-dealers experienced disruptions in their trading system operations that prevented them from routing customer orders to the designated market center for execution on a timely basis. Although disruptions occurred throughout the day, capacity problems were particularly high just after the opening of the market and prior to the close of trading on October 28. An unusually high numbers of orders that queued up in broker-dealers' internal order handling systems prior to the opening of trading on October 28 helped precipitate these problems. In addition, a number of broker-dealers were forced to manually execute some customer orders because mainframe computer capacity problems prevented automated routing systems from sending orders to designated market centers for execution.
C. Adequate Capacity Should be a Top Priority for Broker-DealersThe Commission has long been concerned about the need to take steps to prevent capacity or other operational problems from disrupting market operations. Previously, the Commission published two Automation Review Policy ("ARP") statements9 that address the technological capacity needs of participants in the securities markets. The policy statements highlighted the Commission's concern that market participants, including exchanges, clearing agencies and broker-dealers, take voluntary steps to establish comprehensive planning and assessment programs to determine systems capacity and vulnerability.10 The first policy statement in particular discussed the importance of: (i) formally establishing capacity estimates; (ii) conducting periodic capacity stress tests; and (iii) contracting with independent reviewers to assess performance at current and future capacity levels and to assess vulnerability to physical threats.11
With this bulletin, the Division seeks to emphasize to broker-dealers the importance of having adequate capacity to handle high volume or high volatility trading days, and conducting capacity planning on a regular basis. The Division does not intend to mandate standards for broker-dealer capacity at this time. Rather, the Division encourages broker-dealers to look to the guidance provided by the ARP statements, and to consider other appropriate measures to minimize potential capacity problems. These might include developing backup technology systems and procedures for handling system capacity problems. Online broker-dealers could consider additional steps, including: employing multiple ISPs, implementing class "B" Internet addresses to improve access quality, improving server capacity, giving priority at times of peak usage to customers who wish to enter orders (i.e., preventing non-customers from accessing websites to review financial information), educating customers about Internet access issues, and providing alternatives means to place orders when Internet access is slow or unavailable.
As discussed above regarding circuit breakers, broker-dealers should use every reasonable effort to notify customers about operational difficulties. Broker-dealers also need to properly record all customer complaints, including e-mail complaints, as required by SRO and Commission rules.
D. Outsourcing Does Not Excuse Broker-Dealers from Focusing on Capacity IssuesSome broker-dealers have delegated responsibility for their technology operations, including trading systems, to outside vendors. Those broker-dealers should recognize that they are not excused from taking the steps necessary to ensure that adequate systems are in place merely because they rely on outside vendors. They need to exercise oversight of vendors' operations,and ensure that vendors adequately address capacity problems.12