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As the global economy falters and a financial crisis beckons
due to the unprecedented Covid-19 pandemic, our latest primer
looks at the circuit breakers used by US securities markets to
prevent freefall. These little used mechanisms had not been
seen since 1997, but have become an almost daily occurrence
during this crisis, activating on March 9,12 and 16.
What are market circuit breakers?
In US securities markets there are three ways to dampen
intraday volatility – one of which is market wide
circuit breakers (MWCB). Under these standards, when the
S&P500 index declines by a specified percentage it
automatically triggers a 15-minute pause in all equities and
Circuit breakers were introduced in 1987 following a flash
crash in the equities market that caused a 23% drop. Sometimes
the market doesn’t move significantly for
fundamental reasons, but simply because a large size
transaction takes place that triggers momentum-based trading by
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The triggers for MWCB are based on the previous
day’s close of the SPX index. The three levels are
7%, 13% and 20%. The first two levels trigger 15-minute pauses
in the market if breached prior to 3:25pm EST. If triggered
after that time, the market will stay open until the normal
time of 4pm EST. The third-level breach of 20% down from
previous SPX close will close the market for the rest of the
day at any point.
"Market-wide circuit breakers enforce a trading pause so
that investors have time to absorb information, better
understand what’s happening in the market, and
make decisions accordingly," writes Stacey Cunningham,
president of the New York Stock Exchange.
If the index declines by more than 20%, trading is halted
for the day. "The idea is that it gives the market the
opportunity to absorb and digest events so that trading can
occur in an orderly fashion," says Colin Lloyd, partner at
What are the other measures to dampen
The second method of preventing market volatility is known
as the Limit Up-Limit Down (LULD) mechanism, which is used to
prevent trades in individual securities from occurring outside
of specified price bands. If an individual stock exceeds a
particular limit, which is established by the exchanges for
each individual stock, the stock will enter into what's known
as a limit stage, meaning trading cannot take place. If trading
can't take place within that band within 15 seconds, then the
primary listing exchange will declare a five-minute trading
halt for that security.
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The average price is taken over the last five minutes of
trading, then a band is placed around it. It is usually plus or
minus five percent, although this number varies. A message goes
out to everybody involved. "It’s basically
designed to keep stocks from moving too far too fast. When
something does happen to a stock it goes into the LULD and
there is a hole in the auction," says James Angel, professor at
Georgetown Law. "It keeps things from getting too insane. One
of the problems we have is that in our completely automated
markets where computers mechanically match, buy and sell orders
– that's all they do – there is nobody
monitoring things to ask if a price make sense."
"So if somebody puts in an order to sell a security at a
penny, well – guess what – it might be
executed and sold at a penny," he adds.
The third measure is a short sale restriction. If a stock
has declined by 10% in one day then there is a short sell
restriction preventing market participants from executing or
displaying a short sale at a lower price.
Why are circuit breakers so important during a
Circuit breakers provide an opportunity to pause trading for
a period of time so that traders can take stock and decide
whether it makes sense to continue selling or not.
"MWCBs are critical to help maintain orderly markets in
times of stress," says Michael Beth, vice president of equity
and derivatives trading at Wallach Beth. "It limits the amount
the overall market can go down before a pause, giving relief to
participants, and in extreme cases will cause the market to
close for the day."
"Circuit breakers are a good safety check in the market," he
continues. "It’s strictly a way to make sure flash
crashes and other adverse scenarios do not occur as readily.
Markets can still sell off after a level is breached, however,
it gives participants the ability to reevaluate and press pause
on a potential panic."
In times of crisis – such as that caused by
Covid-19 – a lot can happen in a short space of time.
Markets don’t necessarily act how they should.
Buyers and sellers don't always match. Sometimes
there’s a gap, and sometimes that gap is
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A system that immediately matches every buy order with
whatever sell interest is in the book, or vice versa, will end
up with an incredibly volatile stock price. This doesn't
reflect the consensus of supply and demand.
"For example, during the flash crash in 2010 the market was
overwhelmed by volume, and we saw crazy prices," says Angel.
"In those circumstances it makes sense to have, as they say,
the pause that refreshes."
What issues are there with existing circuit breaker
Given the current global situation, it’s clear
that the market is spooked. Market-wide circuit breakers are
being tripped with much higher frequency than in normal times.
"Most of those trips were totally unnecessary. The way we open
our markets is actually quite elegant, and not fully
appreciated by a lot of people," says Angel.
When morning comes, most traders already have a good idea as
to how it will look at the opening bell. There’s
overnight futures trading, and at 4am some exchanges turn on
their computers and adventurous investors enter the market for
pre-opening trading. By 9:30am, there are few surprise
But if the market opened down and was then immediately
halted, it makes no sense at all," says Angel. "The market had
already been halted. It doesn't make sense to open it up with
an auction and then halt and then wait 15 minutes for another
auction. It really makes no sense at all."
One solution would be to start the clock in the morning
based on the opening auction, rather than the night before.
Circuit breakers remain an important means to dampen
volatility. "When a circuit breaker is triggered, especially in
the middle of the day like a major event or announcement, it is
very useful," says Lloyd.
Is there an alternative?
Various market participants have called for a temporary hold
on all market trading, as seen in the days that followed the
September 11 attacks. This would be a decision between
regulators and exchanges.
Both have insisted there is no such plan in place.
Ensuring that the markets remain open will help to ensure
stability. "It’s important that markets continue
to function. Closing them can have fairly significant
downstream effects on investors, who may need access to cash
for daily life or business expenses," adds Lloyd. "Not being
able to sell securities could be a problem."
There are others – institutional investors, for
instance – who typically have large numbers of
outstanding derivative short positions. It’s
important for them to be able to trade actively to manage those
positions. They would be exposed to a huge amount of risk if
markets halted trading altogether for an unspecified period of
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