Timeout From Trading
In the world of electronics, circuit breakers cut the flow of electricity when there’s an overwhelming surge of power. In stock markets, they do pretty much the same thing. Introduced in the U.S. after a 23 percent crash in the Dow Jones Industrial Average on Black Monday in 1987, circuit breakers trigger a timeout from trading after prices tumble by a predetermined amount. Their use has spread globally as a tool to take the sting out of market meltdowns — and to address the risk of erroneous trades in an era of high-frequency trading. They can also backfire, as China and the U.S. have experienced, adding to the volatility they’re intended to curb.
Circuit breakers lasted just four days in China. Introduced at the start of 2016, the measures required the market to be closed for the rest of the day if the benchmark index fell by 7 percent. On the first day of trading the market was shut in the early afternoon; three days later it was closed in less than 30 minutes. The circuit breakers were blamed for deepening the selloffs and even feeding the panic as investors dumped their shares in fear of being left holding them in the event of a shutdown. Chinese authorities, concluding that the negative impact outweighed the positive, suspended the rules indefinitely. In the U.S., as well as circuit breakers for the overall market, limits for individual securities were introduced as a direct response to the so-called flash crash of 2010, when the Dow sank to a 9 percent loss in just minutes. In August 2015, those single-stock circuit breakers produced unprecedented disruption as 327 exchange-traded funds experienced more than 1,000 trading halts during a single day. European Union regulators will require circuit breakers for high-frequency and algorithmic trading from 2018, part of a broader effort to control systemic market risks. In August, Hong Kong's exchange will restrict large stocks from moving more than 10 percent during a five-minute period, a rule aimed at stopping so-called fat fingers and rogue algorithms from causing erroneous price swings.
Former U.S. Treasury Secretary Nicholas Brady is credited with bringing circuit breakers to stock markets, part of his committee’s recommendations to President Ronald Reagan following the 1987 crash. Those rules shut the U.S. market early for the only time on Oct. 27, 1997, following a 7.2 percent plunge in the Dow. The benchmark for circuit breakers was later switched to the larger S&P 500, and the boundary limits have changed to percentage moves from points. It now takes 7 percent and 13 percent drops to prompt a 15-minute pause in trading, and a 20 percent decline to close U.S. markets for the day. China adopted circuit breakers after a $5 trillion stock rout in mid-2015 left policy makers struggling for measures to contain the turmoil. Chinese Premier Li Keqiang later criticized the nation’s financial regulator and replaced its top official. The new chief said China wouldn’t be ready to reintroduce circuit breakers “for years.” Countries that employ circuit breakers for the overall market include Japan, Brazil and South Korea. Single-security limits are widely used from the U.K. and Spain to Singapore and India.
Proponents say circuit breakers act as a speed bump during rapid market declines. They help to restore calm and can even build confidence in markets. The main concern is how to set thresholds: Too wide and they may never be used, too narrow and they can lead to the chaos seen in China and the U.S. China’s trigger point — a 7 percent decline in the Shanghai Shenzhen CSI 300 Index — would have been breached eight times in 2015, suggesting that a wider limit was appropriate. Academic studies mostly agree that circuit breakers are prudent, but offer little evidence that they reduce volatility after trading recommences or that they cut panic-driven selling. Opponents say the interruptions unacceptably interfere with efficient pricing. They also point to drawbacks including the “magnet effect” seen in China, when traders push forward their transactions as a price approaches its boundary. Even skeptics agree that circuit breakers can serve to counteract erroneous trades that risk sending markets into a tailspin, particularly as computerized trading proliferates. According to a 2010 Hofstra University paper, circuit breakers “serve best to remind us when volatility has become intolerable, but the measures do little in practical terms to stymie insufferable declines.”
The Reference Shelf
- The 1988 Brady Commission report that first recommended the use of circuit breakers.
- Nicholas Brady, the former U.S. Treasury Secretary responsible for the report, gave Bloomberg News his thoughts on China’s experiment: “They’re just on the wrong track.”
- A 2012 report for the U.K. government looked at the case for and against circuit breakers.
- The New Yorker opined on the “dubious logic” of circuit breakers.
- ITG produced a report listing the use of circuit breakers in different countries.
First published March 2, 2016
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Grant Clark at firstname.lastname@example.org