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Circuit breakers are an effective tool to manage volatility, according to a new paper – Circuit breakers and market quality – from the World Federation of Exchanges (WFE).
The paper, which is its second on the subject, found that on average, stock returns stabilise, selling pressure resolves, and prices become more informative after trading resumes from a market wide stoppage in trading.
The paper also demonstrated that traders tend to hold back from aggressive trading right before trading halts, which is inconsistent with the circuit breakers causing panic, the so-called magnet effect.
Although not new, these events have been in the spotlight since March 2020 when the volatility induced by Covid 19 triggered market-wide circuit breakers on four occasions.
WFE Research used a sample of stocks around the S&P500 index cut-off to analyse how market quality measures, including stock returns, volatility, spread-based measures, order imbalance, and market microstructure measures, evolve around market-wide trading halts.
Comparing these measures before and after the market wide circuit breakers (MWCBs), the report showed that, in general, the market condition improves significantly after the trading halt.
Investigating the evolution of the market conditions leading to the MWCBs, there was evidence inconsistent with the presence of magnet effects.
WFE Research also compared the effects on S&P500 firms with non-S&P500 and did not see any significant differences in the effects of the MWCBs between the stocks at the bottom of the S&P500 index and those just outside the market index, suggesting that index membership or index funds do not have additional impacts on market quality during MWCBs.
In addition, comparing the effects of MWCBs with single stock circuit breakers, the report noted that liquidity suppliers tend to become more reluctant to provide liquidity after MWCBs than after the single stock halts.
“In our study of circuit breakers published last year, WFE Research described the different safeguarding mechanisms that exchanges use to ensure market quality,” said Dr Pedro Gurrola-Perez, head of WFE Research & one of the authors of the paper.
He added, “In this new research paper, we now study their impact from a market microstructure perspective. While exchanges around the world calibrate their safeguarding mechanisms according to the characteristics of their markets, our results contribute to our overall understanding of these mechanisms by providing empirical evidence of their effectiveness in the case of the US markets.
Nandini Sukumar, chief executive Officer of the WFE said, “These results have important policy implications, as they indicate that the circuit breakers triggered during March 2020 contributed to alleviating the pressure in the financial market.
We find that the circuit breakers in the US are designed adequately and serve as an effective safeguarding mechanism employed by the exchanges. Overall, the WFE Research findings point to the efficacy of the circuit breakers as an efficient safeguarding mechanism employed by the exchanges.”
This article first appeared in Best Execution, a Markets Media Europe publication.