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SEC's Weird Circuit Breaker Loophole

Wednesday, 19 May 2010 | 2:33 PM ET

Many traders a bit baffled as to why the SEC excluded exchange-traded funds (ETFs) from the new circuit breaker rules. Especially hard to understand since two-thirds of the securities that had busted trades were ETFs.

Regardless, this may create some real volatility in ETFs, should the circuit breakers be triggered in a large number of stocks.

For example, suppose 10 stocks in the S&P 500 hit the circuit breaker: they dropped 10 percent in 5 minutes. Trading is now paused for 5 minutes. But these 10 stocks are also components of many ETFs — including the largest, the SPDR 500 ETF Trust.

What happens to the SPY when some of its components are not trading and the SPY IS trading?

It's not clear, but some obvious observations can be made:

1) in that period, the market will reflect where traders think the underlying securities MIGHT open

2) the bid/ask spread in the SPY will widen to reflect that uncertainty.

This will likely not last long. The SEC says that it plans "to expand the scope to securities beyond the S&P 500 (including ETFs) as soon as practicable."

Just hope things don't get too volatile in the interim.

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  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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