FLASH FRIDAY: Market Circuit Breakers Come Into View

Bang! Wop! Kazowee!

Sounds and images that harken back to the original Batman television show when the title character would hit or strike one of his adversaries. Or when the Batman himself got hit.

That’s how the stock market must feel recently after multiple days of severe selling hour after hour, day after day, stoked by the spread of Covid 19 and its expected effects on the global economy and markets. But traders and investors do have some protection unlike when Batman was chasing around the Joker or the Penguin – market circuit breakers.

The equity markets recently have seen the circuit breakers – also referred to as “limit up/limit down” mechanisms – help halt market free falls and given traders and investors a 15 minute pause in trading in which to assess market systems, trading strategies or even just catch their collective breath. But it hasn’t always been this way.

“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,” New York Stock Exchange President Stacey Cunningham tweeted in the afternoon of March 9. “The halt in trading this morning means that the market-wide circuit breakers functioned exactly as designed.”

Looking back, market circuit breakers trace their origins to the 1987 Black Friday market crash. They have been employed in one form or another since but came into recent focus as a result of the May 6, 2010 Flash Crash when between 2:32 EST to 2:45 EST the stock market plummeted for 36 minutes and caused trillions of dollars of losses. On that day, The DJIA plunged 998.5 points (about 9%), most within minutes, only to recover a large part of the loss. After investigations, hearings and research, market officials announced that new trading curbs, circuit breakers, would be tested during a six-month trial period ending on December 10, 2010. These circuit breakers would halt trading for five minutes on any S&P 500 stock that rises or falls more than 10 percent in a five-minute period. The circuit breakers would only be installed to the 404 New York Stock Exchange listed S&P 500 stocks. The first circuit breakers were installed to only 5 of the S&P 500 companies on Friday, June 11, to experiment with the circuit breakers. After tweaking and more widespread application, today’s circuit breakers have emerged.

During the regular trading session, the threshold of declines to trigger circuit breakers is as follows, according to the New York Stock Exchange:

Trading halts for 15 minutes if the S&P 500 drops 7% against closing prices the prior session

Trading halts for 15 minutes if the S&P 500 drops 13%

Trading halts for the rest of the session if the S&P 500 drops 20%

Traders Magazine takes a look back at market circuit breakers.

The following article originally appeared in the December 2010 edition of Traders Magazine

The market-wide circuit breakers have been in place since the 1987 crash may be getting an updating.

“We are assessing whether various aspects of the broad market circuit breakers need to be modified or updated in light of today’s market structure,” Securities and Exchange Commission chairman Mary Schapiro testified during a U.S. Senate hearing last month.

A change is due, said David Shillman, an associate director in the SEC’s Division of Trading and Markets, because the market has become “faster and more electronic.”

The official told the crowd at the recent Investment Company Institute conference that the 23-year-old circuit breakers had almost never been triggered and that a change would involve “tightening the bands with a shorter duration.” Today, the circuit breakers halt trading for at least 30 minutes whenever the Dow Jones Industrial Average falls by at least 10 percent.

The comments by the SEC officials follow the exchanges’ implementation of circuit breakers on individual stocks that halt trading for five minutes if a stock falls or rises by 10 percent or more. Those became a part of the market structure due to the “flash crash” on May 6.

Fast forward to the events of Aug. 24, 2015, which were a wake-up call for many in the exchange-traded fund (ETF) industry. After a market selloff in Asia spread to North America on that day, another “flash crash” ensued – creating upheaval in the US equity markets. In addition to widespread market volatility, ETFs were hurt by diminished liquidity and price dislocation. This was due in part to the breakdown of trading mechanisms that were designed to prevent volatility.

Within a year, the Securities and Exchange Commission (SEC) enacted several changes designed to stem market volatility, including abolishing its controversial Rule 48 – a mechanism designed to ensure orderly trading, but one that created its own set of problems.

Left unresolved were harmonization between exchanges and the shortcomings of limit-up/limit-down rules. These rules were originally intended to put the brakes on extraordinary market volatility by halting trading in a security. But they occasionally do the reverse by reducing price visibility and preventing a security from recovering after a sharp price drop.

These issues are now being addressed. On Jan. 19, the SEC moved to amend its circuit breaker rules – formally known as The National Market System Plan to Address Extraordinary Market Volatility– by adopting what’s known as Amendment 12.

What is Amendment 12?

Amendment 12 establishes guidelines for reopening trading in securities following a limit-up/limit-down pause. Here are the three key provisions:

  1. Following a trading pause, no equity exchange can reopen trading in a security until after the primary listing exchange reopens trading in that security.

This means that liquidity will typically be centralized within the primary market, as opposed to being fragmented across multiple venues for the reopening print. In my view, this attempt at a single point of transparency is essential, particularly during periods of marketwide stress.

It’s important to note that the SEC has set forth an exception to the above rule:

1a. Following a trading pause, the only time trading in a security can resume outside of the primary listing venue is if the primary listing exchange is experiencing problems related to its systems or technology.

This is a precautionary measure that provides redundancy in the event of a technology breakdown. In such cases, trading would resume at the last effective price band.

  1. If a trading pause occurs in the last 10 minutes of a trading day, the primary exchange will, if possible, attempt a closing cross procedure, rather than trying to reopen for continuous trading.

This clarifies how the exchanges would handle a trading pause after 3:50 p.m. ET. Rather than re-establishing continuous trading for 10 minutes or less, priority is given to an orderly close.

  1. Exchanges may create synthetic price bands when attempting to reopen after a trading pause and there is a reference price available, but no limit-up/limit-down price bands available.

Even a miniscule amount of time between a trading halt and the creation of a new trading range can lead to severe price dislocation for orders in the queue. The dislocation occurs when trading starts before publication of new price bands. The goal of providing synthetic (consistent) price bands across exchanges is to prevent this leaky band syndrome.

The changes set forth in Amendment 12 should reduce the number of repeat trading pauses in a single stock or ETF, in my view. I believe they represent progress toward establishing a more standardized process across primary listing exchanges for reopening trading following a trading pause.

More specific information about the SECs official approval order for Amendment 12 can be found here.