Market Circuit Breakers as Regulatory Zombies

Last month the Securities and Exchange Commission and stock exchanges started another experiment with circuit breakers. The new rule puts a stop to trading for five minutes if the price of a share moves by 10% or more within the past five minutes. The supposed object is to dampen volatility. So far, all the rule has done is to magnify the impact of obvious typing errors.

Similar emergency breakers were put in place decades ago and proved to be either useless or worse, themselves  a cause of volatility. But discarded regulations come out of the crypt whenever people need to show they’re doing something.

After the record crash in 1987 known as Black Monday, regulators instituted a rule  requiring a pause in the trading of stocks if the Dow Jones lost a certain number of points. If the index continued to go down, the market would be repeatedly shut off. The idea was to allow a time-out to stop prices from plunging in a panic.

This had a perverse effect in the 1990s as the stock bubble formed. Investors thought circuit breakers would act as a safety net to protect high share prices—of course a false belief. In late October 1997, when the Dow dropped precipitously, the stops on trading created an artificial backlog of sell orders. Knowing that they were not going to be allowed to trade for a while made investors more inclined to take their money out, worsening the decline.

A study led by Vernon Smith “found that circuit breakers generally made bubbles worse and certainly did not eliminate them,” to quote Ross Miller in Experimental Economics: How We Can Build Better Financial Markets (John Wiley & Sons, Inc. 2002).

Mr. Miller describes the 1997 incident as “regulatory folly.” Instead of breaking the market’s fall, the time-out requirement acted like a magnet, pulling prices further down as traders dumped their holdings as fast as they could so as not to get caught in the expected pauses.

After this experience circuit breakers lost their attraction as volatility cure, at least for a while. Some lessons were learnt—-unlike the 1987 rule, the current versions come into action when there is a certain percentage decline, rather than a loss of a certain number of points.

The new rule is for single stocks rather than indexes. It applies to stocks in the S&P 500, but SEC Chair Mary Schapiro is quoted as saying, “It is my hope to rapidly expand the program to thousands of additional publicly traded companies.”

What’s happened since the introduction of the program is that the breakers were tripped off by errors.  Trading in Anadarko Petroleum (APC) was halted because a price of  $99,999 was entered—-a mistake, quickly erased. Same thing happened with the shares of Citigroup (C) and Washington Post (WPO).

Preventing errors is very worthwhile and trading technology should be improved. But circuit breakers don’t do that, they just stop the trading after a large error has occurred.

Now, one could argue that in their current form they’re not likely to do much harm, unlike the 1987 breakers. They’re probably not particularly useful, but not destructive, either.

But why is it that failed regulations never die? It’s like one of those science fiction movies where the zombies keep breeding and multiplying.

Disclaimer: This page contains affiliate links. If you choose to make a purchase after clicking a link, we may receive a commission at no additional cost to you. Thank you for your support!

About Chidem Kurdas 58 Articles

Chidem Kurdas is a financial journalist, analyst and writer.

Throughout her career she has held numerous positions, including: Research Analyst at Thomson Reuters, New York Bureau Chief at HedgeWorld, News Editor at Infovest21, Senior Associate Editor at Medical Economics Publications at The Thomson Corporation. She is currently Editor at Opalesque Futures Intelligence.

She holds a PhD in Economics from New School University.

Visit: Mutual Fund Smarts

Be the first to comment

Leave a Reply

Your email address will not be published.


*

This site uses Akismet to reduce spam. Learn how your comment data is processed.