ABSTRACT

Circuit breaker, an automated regulatory instrument employed to deter panic, temper volatility, and prevent crashes, is controversial in financial markets. Proponents claim it provides a propitious time-out when price-levels are stressed and persuades traders to make rational trading decisions. Opponents demur its potency, dubbing it a barrier to laissez-faire price discovery process. Since conceptualization in 1970s and practice from 1980s, researchers focused mostly on its ability to allay panic, interference in trading, volatility transmission, prospect of self-fulfilling prophecy through gravitational pull towards itself, and delayed dissemination of information. Though financial economists are forked on circuit breakers’ usefulness, they’re a clear favorite among regulators, who downplay the reliability of anti-circuit-breaker findings citing, inter alia, suspect methodology and lack of statistical power. In the backdrop of 2007-2008 Crisis and 2010 Flash Crash, the drumbeats for more regulatory intervention in markets grew louder. Hence, it is unlikely that intervening mechanism like circuit breakers will ebb. But are circuit breakers worth it? This paper synthesizes three decades of theoretical and empirical works, underlines the limitations, issues, and methodological shortcomings undermining findings, attempts to explain regulatory rationale, and provides direction for future research in an increasingly complex market climate.

PROS & CONS

The integrity of a financial market relies heavily on the integrity of pricing. Prices determine worth, dictate where savings will be mobilized and channelized, resources will should be allocated, and liquidity will be sought or provided. Thus, when a market fails to facilitate price discovery and signaling to the extent that supply and demand no longer are the key determinants, a problem emerges. Therefore, regulatory intervention to iron out such kinks has merit. Nonetheless, whether the employed mechanisms have untoward consequences or fail to achieve professed objectives—or worse, impair market quality—warrants examination. The debate of whether circuit breakers are merited depends on a variety of factors:

Type of circuit breaker
o Is it a price limit or a trading halt?
o Is it a call auction?
o Is it discretionary or rule based?

• Triggering mechanism
o Is it induced by order?
o Is it induced by volume?
o Is it induced by price?

As of 2018—the time of writing this paper—data collected for Table 1 in this paper indicates 48 trading halts, 98 price limits, and 31 volatility interruption mechanisms active among the studied 152 exchanges, with some venues opting for multiple, overlapping, and/or discretionary schemes. In 16 cases, continuous trading is paused, leading to an auction. Meanwhile, with regards to trigger parameter, 11 venues activate the circuit breaker on discretionary basis; meaning pre-set values are not publicly disclosed.

Historically, the Brady Commission Report, sanctioned by Reagan administration in 1988 to uncover why the 1987 crash happened, was the first formal paper to advocate market-wide and individual circuit breakers. Latter proponents invoked the cooling-off hypothesis propounded by Ma, Rao, and Sears (1989), which argued circuit breakers could enforce price stability by curbing large price swings caused by speculative overreaction, avert panic, and dissuade price manipulation. Advocates also argue that traders’ ability to modify or withdraw standing limit orders during the halt enables informed traders to manage their risk without incurring losses, which in turn will increase liquidity and participation around equilibrium price upon resumption (Copeland & Galai, 1983). Moreover, circuit breakers are hoped to educate the market when channels of information transmission (i.e. quotes) are absent (Greenwald & Stein, 1988) and in so doing promote price discovery and decrease information asymmetry.

Both price limits and trading halts brake the price change mechanism. Whether this slowing-down is beneficial depends on the source of volatility. If the source is newly available fundamental information, the halt is only delaying the inevitable. Trade stoppage conveys no information on price expectations and could fuel further panic speculation resulting in greater transitory volatility when trade resumes. However, halt of trade before noise traders execute panic-driven orders would reduce transitory volatility and hence be desirable. Similarly, if excessive noise trades cause an order imbalance, halts could benefit the market by protecting noise traders from losses stemming from operating in a market with sub-optimal depth. Moreover, this allows market makers a chance to enter the market and provide liquidity (Kodres & O’Brien, 1994). In this scenario, Greenwald and Stein’s (1991) theoretical model shows informed traders’ transactional risk drops when prices move fast due to uninformed trades as value-seeking traders cautiously retreat since they are unsure at what price their trades will execute. Consequently, market participants have a greater incentive to be more informed before opening or closing a position.
Trading halts can also give brokers more time to collect margins. Brennan (1986) argued circuit breakers can act as a partial substitute for margin requirements if market participants are unsure about the eventual equilibrium prices during the timeout period. For example, a commodity trader posting 8% margin will lose all if price goes down by 20%. Should an 8% fall happen immediately, though the trader should lose his whole position, in practice, he only loses the 8% margin, and the broker stands to collect additional 12% later. However, with a circuit breaker of 10% in place, and neither the trader nor the broker knowing the eventual price trajectory to be 20% lower, the trader has an opportunity to attend to the first margin call voluntarily. This allows the broker multiple opportunities to collect margin when circuit breakers are in place. Failure to meet the margin call gives brokers more time to trade to stop the loss. Moreover, when a security or the market is in duress, stop-loss orders aggravate an already stressed order-book flooded with uninformed orders. In this way, trading halts can decrease transitory volatility. Moreover, an order-driven market may boast higher liquidity with a trading halt mechanism. In these markets, traders offering standing limit order suffuse liquidity. In normal circumstances, if price drops fast, a trader with standing limit orders will incur loss as the price continues to drop. However, a halt changes the mechanism from continuous to single-price auction upon resumption, when all orders are executed at the same settlement price. If a large selling order imbalance exists, all limit order buyers will receive it at the low clearing price. This protects the limit order buyers and encourages them to provide more liquidity in calmer market circumstances.

Contrarily, price limits and halts can increase transitory volatility if traders are afraid that trading will stop before they can submit order, leading to a hastening of order placement to increase the likelihood of execution. This triggers greater volatility, and rational traders recoil from trading amid fast-changing quotes. This phenomenon is known as the magnet effect, coined by Subrahmanyam (1994), who expanded on Lehmann’s (1989) predictions and later theoretically demonstrated this effect. He later postulated that rule-based halts are more susceptible to magnet effect due to higher predictability compared to discretion-based halts (Subrahmanyam, 1997).

There’s a possibility that informed traders may devote less time to monitoring the market if they know that they’ll be notified if trade is halted. Therefore, market liquidity may worsen in between trade halts, exacerbating transitory volatility, and leading—eventually—to more trade halts. For countries with multiple exchanges, a circuit breaker trigger in one market may cause perils in other exchanges. If only one market’s trade stops, order flow diverts to the remaining open market(s). Thus, solitary circuit breaker regimes may be counterproductive. Hence, many early researchers suggested coordination of regulation among exchanges to facilitate meeting higher demand for liquidity in multiple markets instead of one (Lauterbach & Ben-Zion, 1993).

Through a sequential microstructure trade model, Glosten and Milgrom (1985) demonstrate that uninformed traders acquire information by observing the trade process. Thus, trade contains an informational content, which is learnable only when trade is active. This leads to opponents arguing that absence of trade delays price discovery by postponing informed and uninformed agents’ reactions to new information (Fama, 1989). Moreover, if large price moves are induced by heavy one-sided order flow (i.e. order imbalance) and trigger a halt, informed traders are forced to temporize partial or full trading strategies, and whatever volatility was due to take place is splattered over subsequent trading sessions; typically with reduced liquidity (Chordia, Roll, & Subrahmanyam, 2002; Seasholes & Wu, 2007). Regarding this, Roll (1989) remarks: “…most investors would see little difference between a market that went down 20 percent in one day and a market that hit a 5 percent down limit four days in a row. Indeed, the former might very well be preferable.”

To sum up, opponents’ view on circuit breakers can be condensed into four points: volatility spillover across subsequent trading session, trading interference, delayed information transmission, gravitational pull or magnet effect hypothesis. After the flash crash of 2010, fresh questions surfaced as to whether the trading halt devices designed in rather simpler trading environments three decades ago are still relevant in today’s high frequency zeitgeist and, if not, to what extent should they be tailored, or should the regulators go back to the drawing board and start anew. The computerization of trading and liquidity provision, coupled with trade decentralization has led to a distinct rise in volume and volatility in the new climate (Brogaard, 2011). Regulators and markets in the US coordinated on a large-scale pilot project after the crash to investigate the efficacy of the classical circuit breaker regime vs. recalibrated narrow band of single stock price limits. Concurrently, European regulators took steps to move away from the endemic discrete circuit breaker regimes towards a unified framework to allow circuit breakers to operate across venues. To what extent this will succeed remains to be seen since exchanges have a vested interest in setting individual rules in a competitive environment to attract order flow. Nonetheless, Biais and Woolley (2011) posit that without tailor-made cross-platform streamlining across markets, circuit breakers cannot be effective anymore since in modern age of high-frequency trading arbitrage occurs across markets and suspending trade in the underlying spot while allowing the derivative trade can be dangerous.

UPSHOT

In the process of surveying for this paper, we have noted a striking similarity between the post-1987 crisis and post-2010 crisis understanding of circuit breakers. In both cases, much hullabaloo ensued in favor of greater regulation of equity and derivatives markets. In the 1990s, a slew of theoretical studies followed to understand if new measures would be beneficial, with a few empirical studies yielding ambiguous results. Paucity of data and a wide array of possible alternative explanations for sources of volatility meant that empirical studies lacked statistical power. In the next phase–new millennium–academia appeared to lose interest in the debate and very few theoretical studies were attempted, coinciding with lack of global crashes. It is interesting to note, however, that the dot-com bubble and crash didn’t inspire any circuit breaker studies. During 2000-2010, with growing availability of high-frequency data, soon a slew of empirical studies followed, mostly on Asian markets. Once again, the results were non-conclusive, though–on average–tilted against regulators. Meanwhile, around the same time, widespread adoption of circuit breakers took place (figure 2). In the final phase, 2010-today, empirical studies became more feasible due to greater availability of long time-series granular datasets, access to order books, limit-up-limit-down databases, and cooperation of exchanges. A noteworthy advancement in this stage has been considering insightful, new, alternative explanations for regulatory intervention and nuanced look at the circuit breaker regimes. Synthetic, laboratory market studies too were conducted, though some of its assumptions are questioned by researchers and industry practitioners. And yet the number of exchanges adopting circuit breakers kept growing, which is not surprising considering the post-crisis market climate. Therefore, now, the upshot is humanity’s understanding of circuit breaker mechanisms remains still limited and compared to the 1990s the progress has not been significant. In light of failure to address core methodological constraints plaguing empirical studies and relative disinterest in theoretical development, regulators defy or downplay academic findings and continue its practice, albeit with periodic tweaking. From a regulatory perspective, the circuit breaker issue is a foregone conclusion, although most are yet to provide empirical justification other than hopeful claims and windy rhetoric. It is not disputed that trading halts may ease the margin collection process for brokers (though others argue the benefits primarily in futures market cannot be generalized to equity), and that halts allow an opportunity to traders to reflect in turbulent times as well as protecting them from an informationally disorganized market when order flows surpass the market’s processing capacity. Innovations in processing capacity and trading algorithms has meant that many of these benefits are less relevant today. Besides, the benefits should be considered against the risk of neglecting the needs of hedgers, arbitrageurs, and investors participating on utilitarian motives, without whom the markets would be empty. Instruments impeding their trading ability are unlikely to be ultimately advantageous. Besides, speculation is necessary for market survival as it incentivizes competition for liquidity. Irrational as uninformed traders may be, denying them chance to participate hurts the informed traders in the long run as they miss out on profitable trading opportunities by exploiting the uninformed traders’ erroneous strategies. Moreover, protecting the interest of limit order traders should be considered as well. They perform a thankless job of providing liquidity and deserve to be compensated for it. Finally, the closing price of a security is a beacon for the economy. Intervention that distorts or impedes the process to discovering a rational price for a security imposes economic costs on the society. Large inter-day or intraday price swings are not necessarily bad or irrational. The cause of the price change matters more than its manifestation. Thus, demonizing volatility indiscriminately only serves to slow the price discovery and by extension result in subpar resource allocation in the economy.

Despite all the short-comings of circuit breaker schemes, innovative measures are on the way. After years of minor fine-tuning and incremental improvements, conceptually complex are and potentially superior mechanisms are garnering more attention. A one-size-fits all mechanism may not be far away. However, until such a solution arrives, circuit breakers are the best ad hoc measures available to stymie the erosion of market confidence. Hence, we conclude in words of Leinweber (2017): “Critics call them “Band-aids”, but for now, band-aids work.”

DOWNLOAD

The full version of the paper is downloadable at the journal’s webpage: https://doi.org/10.1002/ijfe.1709 

CITATION

Sifat, I. M., & Mohamad, A. (2018). Circuit Breakers as Stability Levers: A Survey of Research, Praxis, and Challenges. International Journal of Finance and Economics. https://doi.org/10.1002/ijfe.1709