Market Circuit Breakers as Regulatory Zombies

July 9, 2010

by Chidem Kurdas

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 was halted because a price of  $99,999 was entered—-a mistake, quickly erased.  Same thing happened with the shares of Citigroup and Washington Post.

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.

7 Responses to “Market Circuit Breakers as Regulatory Zombies”


  1. The post 1987 “circuit breakers” came out of the Brady Commission report on the October crash. Greenspan to his credit publicly criticized the recommendations. Brady thought financial markets moved too quickly and people sometimes need to pause and have time to think. View it as a coffee break for financial markets.

    Happy weekend.

  2. Pietro M. Says:

    OT: This piece on the NYT is interesting. It says that Fannie & Freddie didn’t have a role in the crisis because most foreclosures are strategic choices done by wealthy people and not problems created by lax lending to poor. Higher than 1M$ mortgages, says the NYT, suffer credit problems in one case over seven, while lower ones “only” one over twelve.

    There is something missing in the argument, however: no data about the weight on jumbo loans on total mortgages is provided, and no data about jumbo loan losses on total bank losses are available, also.

    Besides, it doesn’t struck me as surprising that loans guaranteed by Fannie and Freddie do not represent major losses for banks. I.e., they are guaranteed. They are tax-payers’ losses, not banks’.

    However, the technicality of the issue and the need of detailed data makes an assessment to difficult for me. However, the article is interesting, also because I tend to the “Austrian” view that data don’t tell much of relevance, and when someone argues using data I just wonder when there may be exceptions to this epistemic problem.

    http://www.nytimes.com/2010/07/09/business/economy/09rich.html

  3. N. Joseph Potts Says:

    Power-wielding third parties are invariably a “bull in the china shop” of exchanges and markets. The power benefits the wielder, and only the wielder, and benefits according to how much “china” the bull can smash.

    The only way for helpful market “regulation” to arise is as voluntary arrangements by market PARTICIPANTS made with EACH OTHER. Consider this matter to its inevitable conclusion, and you will end up a market anarchist.

    Abolish the SEC, and any and all government influence over exchanges.

  4. chidemkurdas Says:

    Jerry,
    That’s interesting about the Brady Commission report on the ’87 crash. Re “Brady thought financial markets moved too quickly and people sometimes need to pause and have time to think,” it sounds intuitively appealing. But in the instances that were studied, the orders did not cease–they just piled up and waited for the break to end. Whether the break makes a difference for traders, beyond their concern about the impact of the break itself, is not clear.

  5. chidemkurdas Says:

    Joseph Potts, we appear to be going in the other direction. Government influence on exchanges is increasing.

  6. chidemkurdas Says:

    Pietro,
    My take on that article was different. I thought people with other homes would obviously be more willing to abandon a property to foreclosure–they have other places to live.

  7. Pietro M. Says:

    Chidem: yes, I imagine both that explanation or that wealthy people have less problems finding lenders than poorer ones, who risk being banned from the credit market. Besides, wealthy people may be more financially sophisticated. However, what’s the relevance of the article in proving that Fannie and Freddie are innocent for the credit crisis?

    I usually considered that two institutions guaranteeing 50% of a 12 trillions market through government guarantees and privileges was a relevant source of moral hazard which was a sufficient explnation for the financial troubles of the last decade (combined with easy money policies). Does the article provides a good argument to change my mind?

    In other words, assuming that F&F surely played a role in the boom by guaranteeing mortgages with tax-payers’s money and easy credit and regulatory privileges, did they also play a role in the bust, by imposing losses on banks (I don’t think so, the losses were forced on the taxpayers who bailed out F&F), or maybe by removing a source of guarantees and thus liquidity (of inherently illiquid long assets) which played a key role in the investment strategies of the banks?

    My hypothesis is that banks were short on ABCP and long on mortgages, that people invested on ABCP because they thought mortgages were secure, that F&F contributed to this perception with their guarantees, and that their bankruptcy contributed to the deleveraging process by scaring ABCP investors and depriving maturity mismatched banks in desperate need of debt rollover of liquidity.


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