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July 1, 2012

Circuit Breakers Get Tightening

By Peter Chapman

They have only triggered twice in the past 24 years and may not trigger often in the next 24.

The mechanism that shuts down the market in the event of a calamitous drop in prices was recently updated for the electronic age. In May, the Securities and Exchange Commission approved a plan by the nation's exchanges to lower the trigger from a 10 percent drop in the Dow Jones Industrial Average to a 7 percent drop in the S&P 500 Index.

The revision in the threshold is the third. The first came in early 1997. The second came in 1998, when the trigger was changed from one based on points to one based on percentages.

Niki Beattie

In their original deployment from October 1988 to May 1998, the circuit breakers triggered twice on Oct. 27, 1997, during the Asian financial crisis. In their current deployment, the circuit breakers have never triggered. They did not trigger on May 6, 2010, when the market fell 8.6 percent during the "flash crash." That convinced regulators the threshold needed to be lowered.

Since then,the exchanges have installed single-stock circuit breakers that halt trading in individual securities when they rise or fall by at least 5 percent. More recently, the SEC approved limit up/limit down (see article on page 26), a refinement of the single-stock circuit breakers.

These additions could make the marketwide circuit breakers redundant. They certainly would have been superfluous during the market flip-flop of the flash crash. "During the pauses, the rebound would have started, so we would not have hit the 7 percent trigger level and there would be no marketwide trading halt," Jim Angel, an expert in market microstructure and an associate professor at Georgetown University, told the SEC.

To some, particularly the Europeans, having two sets of circuit breakers is overkill. All of the major European stock exchanges incorporate halts in individual securities. None halt trading in the entire market.

"It's managed in single stocks," Niki Beattie, chief executive of the London-based consultancy Market Structure Partners, said of the circuit breaker systems used in Europe and the U.K. "So, if all of the stocks are falling outside of the 5 percent or 10 pecent price band, then a circuit breaker would be triggered in every individual stock. I think that's fair."

Executives at the London Stock Exchange agree. They recently advised the European Securities and Markets Authority that they didn't believe in halting the entire market. They contend their "price volatility interruptions" or single-stock circuit breaker equivalents are enough. "In our view, these controls have been successful in preventing disorderly markets," LSE execs told ESMA last October.

Back in the U.S., if the revised parameters had been in effect since 1988, the circuit breakers would have shut down the market five times: during the flash crash and four times during the tumultuous months of late 2008.

They would not have shut down the market on Oct. 27, 1997, when the S&P 500 Index fell 6.87 percent. Nor would they have shut down.

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