Circuit breakers or short circuits? Flawed stock market controls


An electronic board showing stock movements is seen at a private trading firm in Kuala Lumpur on January 7, 2016. (AFP / MOHD RASFAN)

On any one day last week, you probably heard the term ‘circuit breaker’ more times than you would’ve had you been confined in a hardware store for a decade. Stock market circuit breakers – like the electrical ones that protect your home – are supposed to make trading safer. Do they? For some perspective, CCTV’s Gary Matsumoto looked at their origins and use around the world. 

For some perspective, CCTV’s Gary Matsumoto looked at their origins and use around the world. 

‘Crude tools’

In Beijing and elsewhere, traders and analysts were quick to cite trading curbs as a catalyst in China’s latest meltdown. Criticism was scathing. An article in The Wall Street Journal called them “crude tools.” The Economist headlined one of its stories: “China crashes its stockmarket with circuit-breakers meant to save it.”

The curbs became the butt of jokes in Chinese social media, too. China’s Global Times quoted one student who suggested circuit breakers for China’s grueling final exams: “Stop the clock for an hour when 5 percent of the students agree they cannot work out a question, and end the exam when 7 percent said they still cannot work it out.”

It didn’t take long for circuit breakers to go from scapegoats to punch lines, or both. Where they didn’t go is away. They’re a global fixture. All three cornerstones of the 24-hour market – Tokyo, London and New York – use circuit breakers to protect investors. All three North American markets (the U.S., Canada and Mexico) use them. Until last week, stock exchanges in four of the five BRICS economies (Brazil, India, China and South Africa) used them, too.

Market mavens conceived stock market circuit breakers as a momentum-shifting tool—similar to a time-out in basketball. A coach might call a timeout to slam brakes on an opposing team’s scoring run. Circuit breakers are supposed to stop runs on stocks.

All runs come to an end. When China’s did last summer, it was a $5 trillion bust. To prevent a repeat, Chinese regulators adopted this time-honored, if imperfect, stratagem.

The United States developed circuit breaker technology after a 1987 crash in Asian markets triggered a global investor wipeout. Sound familiar? The Dow Jones Industrial Average lost 22.6 percent of its value—the biggest single day loss since the Great Depression. In response, U.S. securities, futures and options exchanges all adopted provisional rules to halt trading based on point drops in the Dow. The U.S. Securities and Exchange Commission (SEC) issued “pilot” circuit breaker rules the following year. Then chairman of the SEC, David Ruder, said the new rules would “calm the fear and panic that occurs when there are steep declines in the stock markets.”

It would be another 10 years before they kicked in. When a “mini-crash” flipped U.S. circuit breakers for the first time on October 27, 1997, SEC regulators questioned whether it should have happened—not unlike the questions Chinese regulators have been encouraged to ask themselves now.

Declines of ‘historic proportions’

In testimony to the U.S. Senate the following year, one of Ruder’s successors at the helm of the SEC, Arthur Levitt, said circuit breakers should be triggered only on “…those rare occasions when the market decline is of historic proportions.”

In other words, circuit breakers aren’t about damage control. They’re about disaster control.

Levitt didn’t think the ’97 mini-crash met that standard. Circuit breakers halted trading after the Dow slid around seven percent that day—the same level that shut down China’s markets. Levitt questioned whether the U.S. tripwire was set too low. He also cited a still unresolved debate on whether the circuit breakers act as a “magnet” that pulls markets down to the next trigger point. Or do they stabilize markets? There was no clear answer.

Changing triggers
Levitt’s priority was keeping markets open. To make that happen, the SEC and U.S. stock exchanges suggested shifting the trigger points higher—to declines of 10, 20 and 30 percent. In theory, that would make it harder to shut down markets. U.S. regulators made the changes. And then they changed them some more.

Were the higher trigger points too high? Even with new and improved circuit breakers, the “Flash Crash” of 2010 vaporized over a trillion dollars in 36 minutes before the market rebounded. The SEC re-tooled, again.

In 2012 the commission lowered U.S. triggers to their current levels—declines in the S&P 500 index of 7 and 13 percent (from the prior day’s closing) would initiate temporary halts, provided they occurred before the last half hour exchanges were open. The SEC also shortened the duration of the first two trading interruptions to 15 minutes. A third trigger, 20 percent, would close exchanges for the day, regardless of the hour.

More complexity

The time-outs got more complex and varied, too. The SEC added what it calls a “Limit Up/Limit Down mechanism,” which suspends trading temporarily in individual stocks if a drastic swing occurs in either direction. The SEC also shortened the duration of the first two trading interruptions to 15 minutes. 

If one measure of success is keeping exchanges open in the middle of extreme volatility, then SEC’s decision to create more complex, nuanced circuit breakers appeared to work last year. On August 24, 2015, the Dow plunged as soon as exchanges opened. In five minutes, the index dropped 1,100 points. Triggers flipped all over the place. There were 1,278 trading halts in 471 different stocks and ETFs. The overall market frayed but didn’t unravel. It stayed open.

Two options only
China’s now suspended system had two options only. A 15-minute trading halt occurred after a five percent decline in the Hushen 300 (CSI 300) — an index representing 300 of the biggest stocks traded in Shanghai and Shenzhen. When markets re-opened and the index sank a total of seven percent, it was game over for the day. 

Chinese regulators didn’t expect the circuit breakers to work flawlessly on their debut. After the first market shutdown, but before suspending the circuit breakers, the China Securities Regulatory Commission discussed its intention to “…constantly improve the mechanism.”

They may be imperfect. And they may be “crude.” But can circuit breakers be effective? James Angel, Associate Professor of Finance at Georgetown University, is selectively skeptical. After analyzing the U.S. circuit-breaker system for U.S. stock exchanges and federal regulators, he concluded the SEC’s Limit Up/Limit Down mechanism works because it initiates trading halts that are temporary, and brief—just five minutes long. 

On the other hand, he thinks in most cases market-wide shut downs should be scrapped, regardless of duration. “You only want to shut down a market if you think it’s broken.” he says. Angel believes total market closures create anxiety, not calm. When people are anxious, they’re prone to panic. Panic distorts prices.

Buy and sell orders on trading screens send messages to investors. While a crash sends a really bad message, Angel believes regulators should keep exchanges open even when they don’t like what it’s telling them. “You shut down only to prevent the creation of bad prices that are so bad that an hour later everyone looks at them and says that was crazy,” he says. 

Angel says the U.S. can learn a lesson from China’s recent experience with market-wide circuit breakers: “The U.S. should get rid of the current ones and replace them with something that makes more sense.”

No one-size-fits-all
The history of this regulatory tool in the United States indicates that as long as the U.S. employs them, circuit breakers will likely remain a perennial work in progress. If past is prologue, the U.S. could change them again, adjusting their parameters to ever-evolving market dynamics and technology advances that alter the way investors trade stocks.

Markets are all-day haggling sessions between buyers and sellers. Economists call this process “price formation.” This makes “value” an ever-shifting social consensus. History shows that consensus can change radically. Radical changes can result in what you might call a wealth evaporation event. Money goes poof! So how do you protect investors from “poof?”

That’s tricky. What’s good for the NYSE and NASDAQ may not be so good for Shanghai and Shenzhen, and vice versa. U.S. and Chinese markets are near polar opposites in trading dynamics.

As you can also see from the table  we assembled with research from the ConvergEx Group, stock exchange circuit breakers are as varied as the markets that employ them. There is no one-size-fits-all.

United States New York Stock Exchange (NYSE) & NASDAQ MARKET-WIDE & SINGLE STOCK CIRCUIT BREAKERS: “Market-Wide trading halts occur if the S&P 500 declines by 7%, 13%, or 20% (called Level 1, Level 2, and Level 3 halts, respectively). Level 1 and Level 2 halts can each occur only once per day.” If the S&P 500 sinks 7% before 15:25 local time, exchanges halt trading for 15 minutes. After trading resumes, a second 15-minute halt occurs if the S&P 500 tumbles further to 13%. If the S&P 500 continues to sink, the ‘floor’ is 20%. If the index loses 20% of its value from the previous close, the market closes for the day.

[ConvergEx]“On May 31, 2012, the SEC approved a  “Limit Up-Limit Down” mechanism to address market volatility by preventing trades in listed equity securities when triggered by large, sudden price moves in an individual stock. The limit up-limit down mechanism is intended to prevent trades in individual securities from occurring outside of a specified price band. This price band is set at a percentage level above and below the average price of the stock over the immediately preceding five-minute trading period. These price limit bands are 5%, 10%, 20%, or the lesser of $.15 or 75%, depending on the price of the stock.” [SEC]

United Kingdom London Stock Exchange Group MARKET-WIDE & SINGLE-STOCK CIRCUIT BREAKERS: “An Automatic Execution Suspension Period (5 minutes plus random 30-second end period) occurs during continuous trading  when an order entered exceeds 5% from the last automated book trade.” [ConvergEx]
Japan Tokyo Stock Exchange, Osaka Securities Exchange/ JASDAQ MARKET-WIDE & SINGLE-STOCK CIRCUIT BREAKERS: “TSE [Tokyo Stock Exchange] allows for two circuit breakers of 15 minutes each, triggered by extreme price moves. If the price moves a certain percent after the first circuit breaker ends, a second circuit breaker will be triggered.” [ConvergEx]
Canada Toronto Stock Exchange (TMX), Venture Stock Exchange (CV), Canada National (CF) MARKET-WIDE & SINGLE STOCK CIRCUIT BREAKERS: “Coincides with NYSE. 7%, 13%, or 20% decline in the S&P 500 will cause a circuit breaker. If Canadian exchanges are open, but US exchanges are not, halts are triggered if the S&P/TSX composite declines 7%, 20%, or 30%. If the price of a single security swings 10% or more within a 5-minute period, trading in that security will halt for 5 minutes. Further, all trades executed at more than 5% beyond the price that initially triggered that circuit breaker will be cancelled.” [ConvergEx]
Mexico Bolsa Mexicana de Valores (BMV) SINGLE STOCK CIRCUIT BREAKER: “If a stock moves by 15% from the previous closing price, trading is halted at the discretion of the exchange.” [ConvergEx]
Brazil BM & F Bovespa MARKET-WIDE CIRCUIT BREAKER: “If Ibovespa (Bovespa Index) falls 10%: 30 minutes. If its falls 15%: 1 hour. If it falls 20%: Exchange may determine the suspension of trading.” [ConvergEx]
China (Hong Kong) HKEx NO CIRCUIT BREAKER: Though, “…the exchange has the right to suspend trading of a security on its discretion.” [ConvergEx]
India National Stock Exchange of India, Bombay Stock Exchange, Ltd. MARKET-WIDE CIRCUIT BREAKER: “If the index moves down 10% from the previous day’s close session before 1:00 pm, the market is halted for 45 min, followed by a 15 min post-halt call auction session. Between 1:00 pm – 2:30 pm, the market is halted for 15 min, followed by a 15 min post-halt call auction. At or after 2:30 pm, there is no halt or call session.

If the index moves down 15% from the previous day’s close session before 1:00 pm, the market is halted for 1 hour and 45 min, followed by a 15 post-halt call auction session. Between 1:00 pm and 2:00 pm, the market is halted for 45 min, followed by a 15 min post-halt call auction session. At or after 2:30 pm the market is halted for the remainder of the day.

If the index moves down 20% from the previous day’s close session any time during the day, the market will be halted for the remainder of the day.” [ConvergEx]

South Africa Johannesburg Stock Exchange NO CIRCUIT BREAKER: “No exchange-wide” (or single stock) “circuit breaker rule.” [ConvergEx]
South Korea Korea Exchange (KRX) MARKET-WIDE CIRCUIT BREAKER: “Triggered when KOSPI or KOSDAQ index falls by more than 10% from previous close for at least 1 minute. Trading is suspended for 20 minutes, then another 10 minutes for auction. The circuit breaker is limited to once per day and is not triggered during last 40 minutes of regular session [sic].” [ConvergEx]
Thailand Stock Exchange of Thailand MARKET-WIDE CIRCUIT BREAKER: “If the index falls by 10% from the previous day’s close, trading is suspended for 30 minutes. If the index falls by 20% from the previous day’s close, trading is suspended for 60 minutes.” [ConvergEx]

Sources: ConvergEx Group, “Traders’ Guide to Global Equity Markets”; London Stock Exchange, “Changes to Price Monitoring (Circuit Breaker) Thresholds (N11/14)”; Japan Exchange Group, “Price Limits/Circuit Breaker Rule”; U.S. Securities and Exchange Commission,Investor Bulletin: Measures to Address Market Volatility”.