Do ‘Circuit Breakers’ Calm Markets or Panic Them?

(Bloomberg) -- U.S. stock trading saw a series of temporary trading halts in mid-March as frenzied reactions to the coronavirus pandemic triggered the market’s so-called circuit breakers. Such pauses in trading -- used by various countries around the world -- are seen as a tool to take the sting out of market meltdowns. They can also help address the risk of erroneous trades in an era of high-frequency trading. Though circuit breakers can curb volatility, they can also backfire, as China and the U.S. have experienced.

1. What’s a circuit breaker?

In the world of electronics, circuit breakers cut the flow of electricity when there’s an overwhelming surge of power. In stock markets, they do pretty much the same thing. Introduced in the U.S. after a 23% crash in the Dow Jones Industrial Average on Black Monday in 1987, the U.S. circuit breakers trigger a timeout from trading after prices tumble by a predetermined amount.

2. How do they work in the U.S.?

An initial circuit breaker, causing a 15-minute pause in market-wide trading, is triggered when the benchmark S&P 500 Index declines 7%. This happened four times in eight sessions in the midst of the coronavirus pandemic: On March 9, March 12 and March 16 the breakers were hit within the first five minutes of trading, while on March 18, the halt came around midday. Two other breakers (which have yet to be triggered) would force another 15-minute pause when the decline reaches 13% and end trading for the day when the decline hits 20%. Halts are also triggered on stock futures and create breaks on individual securities moving down or up. On March 16 alone, there were about 816 single-stock suspensions, according to data from the Nasdaq exchange.

3. Do circuit breakers work?

Academic studies generally agree that circuit breakers are prudent but offer little evidence that they reduce volatility after trading resumes or that they cut panic-driven selling. Critics say the interruptions -- which can cause some trades to be “busted,” or unwound after they are executed -- unacceptably interfere with efficient pricing. There’s also the peril of the “magnet effect,” when traders actually accelerate their selling to try to execute trades before the pause in trading. China adopted circuit breakers after a $5 trillion stock rout in 2015 in a bid to to contain the turmoil. Debuted in 2016, they lasted just four days and were blamed for feeding panic selling and suspended indefinitely.

4. How long have circuit breakers been around?

Former U.S. Treasury Secretary Nicholas Brady is credited with bringing them to stock markets, part of his committee’s recommendations to President Ronald Reagan following the 1987 crash. Circuit breakers, the committee’s report said, provide “a ‘time-out’ to pause, evaluate, inhibit panic, and publicize order imbalances to attract value traders to cushion violent movements in the market.” Until March 2020, U.S. market-wide circuit breakers were activated only once, on Oct. 27, 1997, following a 7.2% plunge in the Dow Jones Industrial Average. The benchmark for circuit breakers was later switched to the larger S&P 500, and the boundary limits changed to percentage moves from Dow points. The so-called flash crash of May 6, 2010 — when the Dow suffered what was then its biggest intraday point decline in history — resulted in new limits for individual securities. In August 2015, those produced unprecedented disruption as 327 exchange-traded funds experienced more than 1,000 trading halts during a single day.

5. Where else are circuit breakers used?

Countries that have employed circuit breakers for the overall market include Japan, Brazil and South Korea. Single-security limits have been widely used from the U.K. and Spain to Singapore and India.

6. What are their benefits?

Proponents say they act as a speed bump during rapid market declines and that they help to restore calm, and can even build confidence in markets. Even skeptics agree they can serve to counteract erroneous trades that risk sending markets into a tailspin, particularly as computerized trading proliferates. According to a 2010 Hofstra University paper, circuit breakers “serve best to remind us when volatility has become intolerable, but the measures do little in practical terms to stymie insufferable declines.” The spasms in financial markets in the wake of the coronavirus pandemic fueled a wider debate about whether or not markets should be left open in times of such uncertainty and volatility.

7. Why not just close markets when things go bad?

On March 17, U.S. Treasury Secretary Steven Mnuchin said, “We absolutely believe in keeping the markets open,” though he didn’t rule out shortening daily trading hours. Top regulators and executives of exchanges have also come out in favor of keeping trading flowing. Closing markets “would not change the underlying causes of the market decline” and “would only further compound the current market anxiety,” NYSE President Stacey Cunningham said in a March 16 tweet.

The Reference Shelf

• The March 9 circuit breaker allowed traders “time to digest.”
• “Close the Markets? Data and Psychology Say Maybe,” a column by Bloomberg Opinion’s John Authers.
• Matt Levine compares alternative views on what circuit breakers are really for.
• The NYSE’s fact page on market-wide circuit breakers.
• The 1988 Brady Commission report that first recommended the use of circuit breakers.
• Nicholas Brady, the former U.S. Treasury Secretary responsible for the report, gave Bloomberg News his thoughts on such curbs in 2016.
• A 2012 report for the U.K. government looked at the case for and against circuit breakers.
• The New Yorker opined on the “dubious logic” of circuit breakers.

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