Commentary: Circuit Breakers Do More Harm Than Good

When you're cruising down a busy highway, finding stop signs in your path can be downright dangerous. At the least, they back up traffic, and at worst, cause accidents. In essence, that's the problem with so-called circuit breakers. In the years after the 1987 crash, the New York Stock Exchange and the Chicago Mercantile Exchange imposed rules that halt or slow trading when prices decline a specified amount from the previous day's close. The idea is to prevent stocks from falling too far too fast.

Unfortunately, circuit breakers do more harm than good. By design, the rules "shut down the markets and stop business from being done," says University of Chicago economist Merton H. Miller, a Nobel laureate and board member of the Chicago Merc who opposes these rules. Circuit breakers that impede index-arbitrage trading, which have been triggered frequently in recent months, can increase volatility. Other circuit breakers at the New York Stock Exchange that could close down the entire stock market have never been invoked. But such a closing could be chaotic: A huge traffic jam of sell orders and mass confusion, even panic, when the Big Board tries to reopen trading. Says Miller: "If these things are hit, it's a problem."

PART PUBLIC RELATIONS. At first glance, circuit breakers seem to make sense. After the Dow Jones industrial average plunged 508 points on Oct. 19, 1987, exchanges worried that another precipitous free fall would so spook investors that many might flee the market for good. The new rules were partly public relations. But officials also reasoned that closing or slowing trading would give shell-shocked investors time to cool off, reassess their positions, and most likely start bargain hunting.

Unfortunately, the rules haven't kept pace with the bull market. While the Dow has tripled since 1987, the triggers on circuit breakers have remained unchanged. Now, they're set to go off at even slight provocation: Index-arbitrage trading can be impeded by insignificant moves of 50 points on the Dow, representing less than 1% of its value as of July 24. So far this year, the New York Stock Exchange has invoked that so-called collar more than 70 times vs. 28 for all of 1995. Many investors probably believe that's good, since computerized arbitrage took much of the blame for the '87 crash. But it has never been proven that arbs hurt the market. In fact, arbitrage can reduce volatility by narrowing price discrepancies between the futures and the cash markets.

Not only that; there's little evidence that these circuit breakers work. Some traders, to be sure, point to the volatile trading of July 16, saying the rules saved the day by averting a panicky sell-off of equities. And it's true that a rebound in stock prices coincided with a trading halt in the Chicago Merc stock-index pits. Because the futures shut down as the Dow was plunging, the theory goes, traders had time to regain their nerve.

Yet on several previous occasions when contract limits were triggered, stocks have continued lower. Four times this year, the 12-point limit on futures contracts based on the Standard & Poor's 500-stock index (equivalent to about 100 Dow points) has done nothing to arrest a steep decline in stock prices. And on Mar. 8, the market blew through the same 20-point limit that supposedly worked such magic on July 16. In every case, it was bargain hunters, not circuit breakers, that saved the day. The stock market found its level when buyers met sellers--which only happens if trading is under way.

The impact of the rules aimed at arbitrage pale beside the New York Stock Exchange circuit breakers. A move of 250 points on the Dow--less than 5%--would shut down trading of stocks altogether, raising the specter of severe disruption and uncertainty. That almost happened on Mar. 8, a Friday, when the Dow plunged 218 points late in the afternoon. Another 32 points would have stranded investors in losing positions over a weekend, certainly undermining public confidence in the marketplace. Fortunately, the market snapped back ahead of the price limit, rallying 46 points just before the close of trading on Friday and setting up a 110-point recovery on the following Monday.

Admitting that some of the rules were obsolete, securities regulators on July 19 came up with a half-hearted compromise. They reduced the time that markets would remain closed once the limits are hit--from one hour to 30 minutes for a 250-point drop. But they also added more limits and left the existing trigger points in place.

A reasonable argument can be made for a very high trigger point at the Big Board in the event of another historic stock-market crash. But the best move is do away with circuit breakers altogether. "You want the price to fall, because that will bring buyers out of the woodwork," says Miller. Truth is, the public doesn't need the placebo. Small investors were tempered during the 1987 crash of the stock market. Those investors who sold in a panic are unlikely to repeat the same mistake. Investors have wised up. Regulators should do the same.

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