Circuit Breakers
Circuit Breakers
(Bloomberg) -- 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 percent crash in the Dow Jones Industrial Average on Black Monday in 1987, circuit breakers trigger a timeout from trading after prices tumble by a predetermined amount. Their use has spread globally as a tool to take the sting out of market meltdowns — and to address the risk of erroneous trades in an era of high-frequency trading. They can also backfire, as China and the U.S. have experienced, adding to the volatility they’re intended to curb.
The Situation
On Feb. 5, 2018, when the S&P 500 plunged as much as 4.5 percent and the Dow Jones Industrial Average tumbled almost 1,600 points — its biggest intraday point decline in history — it wasn't enough to set off the U.S. circuit breakers. It now takes 7 percent and 13 percent drops in the broader S&P 500 to prompt 15-minute pauses in trading, and a 20 percent decline to close U.S. markets for the day. The Dow's loss was greater than the nearly 1,000-point decline on May 6, 2010, the day of the infamous "flash crash," yet in percentage terms it was lower. The flash crash resulted in new safeguards, including limits for individual securities. In August 2015, those single-stock circuit breakers produced unprecedented disruption as 327 exchange-traded funds experienced more than 1,000 trading halts during a single day. In China, circuit breakers lasted four days when first introduced in 2016, also with unwelcome results. They were blamed for feeding panic selling and suspended indefinitely. As of 2018, European Union regulators require circuit breakers for high-frequency and algorithmic trading, part of a broader effort to control systemic market risks.
The Background
Former U.S. Treasury Secretary Nicholas Brady is credited with bringing circuit breakers to stock markets, part of his committee’s recommendations to President Ronald Reagan following the 1987 crash. Those rules shut the U.S. market early for the only time on Oct. 27, 1997, following a 7.2 percent plunge in the Dow. The benchmark for circuit breakers was later switched to the larger S&P 500, and the boundary limits have changed to percentage moves from points. China adopted circuit breakers after a $5 trillion stock rout in mid-2015 left policy makers struggling for measures to contain the turmoil. Chinese Premier Li Keqiang later criticized the nation’s financial regulator and replaced its top official. The new chief said China wouldn’t be ready to reintroduce circuit breakers “for years.” 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.
The Argument
Proponents say circuit breakers act as a speed bump during rapid market declines. They help to restore calm and can even build confidence in markets. The main concern is how to set thresholds: Too wide and they may never be used, too narrow and they can lead to the chaos seen in China and the U.S. Academic studies mostly agree that circuit breakers are prudent, but offer little evidence that they reduce volatility after trading resumes or that they cut panic-driven selling. Opponents say the interruptions unacceptably interfere with efficient pricing. They also point to drawbacks including the “magnet effect” seen in China, when traders push forward their transactions as a price approaches its boundary. Even skeptics agree that circuit breakers 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 Reference Shelf
- 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 China’s experiment: “They’re just on the wrong track.”
- 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.
- ITG produced a report listing the use of circuit breakers in different countries.
First published March
To contact the editor responsible for this QuickTake: Grant Clark at gclark@bloomberg.net.
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