Circuit breakers as market stability levers: A survey of research, praxis, and challenges

• Author: Azhar Mohamad,Imtiaz Mohammad Sifat
• Date: 01 July 2019
• DOI: http://doi.org/10.1002/ijfe.1709
• Published date: 01 July 2019

RESEARCH ARTICLE

Circuit breakers as market stability levers: A survey of

research, praxis, and challenges

Imtiaz Mohammad Sifat | Azhar Mohamad

Department of Finance, Kulliyyah of

Economics and Management Sciences,

International Islamic University Malaysia,

Kuala Lumpur, Malaysia

Correspondence

Imtiaz Mohammad Sifat, Department of

Finance, Kulliyyah of Economics and

Management Sciences, International

Islamic University Malaysia, Kuala

Lumpur 53100, Malaysia.

Email: imtiaz@sifat.asia

Funding information

Ministry of Higher Education Malaysia;

Research Management Centre of Interna-

tional Islamic University Malaysia, Grant/

Award Number: FRGS 15‐232‐0473

JEL Classification: D43; D47; D53

[Correction added on 14 November 2018,

after first online publication: The

reference Clapham, B., Gomber, P.,

Haferkorn, M., & Panz, S. (2017).

Managing Excess Volatility: Design and

Effectiveness of Circuit Breakers. SSRN.

http://dx.doi.org/10.2139/ssrn.2910977

have been added to this version].

Abstract

Circuit breaker, an automated regulatory instrument employed to deter panic,

temper volatility, and prevent crashes, is controversial in financial markets.

Proponents claim it provides a propitious time out when price levels are

stressed and persuades traders to make rational trading decisions. Opponents

demur its potency, dubbing it a barrier to laissez‐faire price discovery process.

Since conceptualization in 1970s and practice from 1980s, researchers focused

mostly on its ability to allay panic, interference in trading, volatility transmis-

sion, prospect of self‐fulfilling prophecy through gravitational pull towards

itself, and delayed dissemination of information. Though financial economists

are forked on circuit breakers' usefulness, they are a clear favourite among reg-

ulators, who downplay the reliability of anti‐circuit breaker findings citing,

inter alia, suspect methodology, and lack of statistical power. In the backdrop

of 2007–2008 Crisis and 2010 Flash Crash, the drumbeats for more regulatory

intervention in markets grew louder. Hence, it is unlikely that intervening

mechanism such as circuit breakers will ebb. But are circuit breakers worth

it? This paper synthesizes three decades of theoretical and empirical works,

underlines the limitations, issues, and methodological shortcomings

undermining findings, attempts to explain regulatory rationale, and provides

direction for future research in an increasingly complex market climate.

KEYWORDS

circuit breakers, financial markets, price limits, trading halts

1|INTRODUCTION

An efficient market, where participants have access to all

information, should not incur heavy overreaction or

underreaction leading to unreasonable volatility. Such a

market would facilitate price signals commensurate with

change in fundamentals. Real‐world markets, however,

exhibit imperfections, where irrational ex ante and ex post

effects of news are observed. Supply and demand are mis-

matched, leading to order imbalance, and potentially

abnormal volatility. Price discovery is impeded. Although

these imperfections are organic in nature, in the sense that

they arise out of market agent"s' own volition, the imposi-

tion of circuit breakers is a regulatory compulsion.

Inspired by electrical engineers who use an automated

switch to protect a circuit from current overload, imposi-

tion of collars on security prices as a market stability lever

gained popularity in the 1980s. Regulators claim its pur-

port is to deter overreaction, enforce control, prevent

crashes, minimize volatility, and protect liquidity pro-

viders. The aftermath of Black Monday crash of October

1987 helped propel circuit breaker praxis to limelight as

an independent regulatory tool. Attention resurfaced after

the 2007–2008 financial crisis and again in May 2010

Received: 17 April 2018 Revised: 16 August 2018 Accepted: 10 September 2018

DOI: 10.1002/ijfe.1709

1130 © 2018 John Wiley & Sons, Ltd. Int J Fin Econ. 2019;24:1130–1169.wileyonlinelibrary.com/journal/ijfe

following a high‐frequency trading linked flash crash.

More recently, flash crashes in cryptocurrency exchanges

thrusted cries for circuit breakers. Case in point: the flash

crash in GDAX exchange that saw Ethereum price nose-

dive from $317.81 to $0.10 in a matter of 45 ms. In view

of these developments, concern is growing afresh among

regulators, investors, and academics about usefulness of

circuit breakers, magnified by potential for exacerbated

volatility due to growing fragmentation of financial mar-

kets. Accordingly, stakeholders in advanced financial mar-

kets are seeking new mechanisms to handle high

uncertainty periods to avert crashes. Meanwhile, in

emerging markets, circuit breakers are, in terms of param-

eters, relatively vanilla. Yet the rate of adoption since mid‐

1990s has been staggering. In fact, the first exhaustive

review of circuit breakers' efficacy contained few prece-

dents—mostly North American (Harris, 1997). The next

formal survey by Kim and Yang (2004), detailing what

makes them so attractive to regulators, included 20

venues. Most recently, Abad and Pascual's (2013) book

chapter, focusing on an overarching theme of holding

back volatility in markets via circuit breakers, reports sim-

ilar number of venues. This paper's methodology and

approach in organizing empirical literature benefits from

Abad and Pascual's (2013) template and lists over 100

active circuit breakers. Our paper advances the discourse

further by underscoring the challenges in circuit breaker

research stemming from theoretical difficulties in

distinguishing between multifold explanations and

stresses the need for experimental studies. Also, we sug-

gest avenues for extending the conventional approach

and underscore the need for incorporating alternative

and preventive mechanisms from a regulatory standpoint.

Lastly, the paper's novelty includes the roles of high fre-

quency algorithmic trading nexus within circuit breaker

discourse, while prognosticating potential sources of dis-

ruption from nascent technologies such as Blockchain.

This paper is organizedthe following way. First, we pro-

vide definitionsof the key, germane terms used in this field.

Next, we discuss the appealof circuit breakers to regulators,

followed by a discussion of its merits and demerits. Then,

we detail the theoretical work done in this field, followed

by analysis of empirical studies on key hypotheses. Then

we discuss the methodological constraints plaguing

research in this areathat makes the findings suspect to reg-

ulators. Finally, we offer direction for future research.

2|TERMINOLOGY

Some of the basic, technical jargons used in this paper are

defined here for convenience of non‐specialist economists

and the uninitiated.

2.1 |Circuit breaker

A circuit breaker is an umbrella term in financial eco-

nomics for a host of regulatory levers employed by secu-

rity market custodians to temper volatility, prevent

crash scenarios emanating from inordinate investor over-

reaction or malfunctioning algorithm, and to preserve

market integrity. In financial markets, following a sub-

stantial price movement, circuit breakers pause or end

trade earlier to allow market participants a time out to

contemplate the fundamentals, gather information, assess

positions, and make rational decisions. Moreover, partic-

ipants not yet in the market receive an opportunity to

provide or add liquidity. Regulators hope this would for-

fend panic, ease price discovery during market duress,

and protect liquidity providers. Most common forms of

circuit breakers are price limits and trading halts.

2.2 |Price limit

A price limit refers to the maximum stipulated magnitude

by which price may deviate from a reference price. Thus,

price limits effectively establish a band of tolerable prices

for a certain period. Depending on the reference price,

which can be last session or day's settlement price, or last

executed price within the same session, price limits estab-

lish a channel of acceptable percentage (or ticks) by

which price may vary. Some index futures are subjected

to a price limit designating a deviation band before cash

market opens. The peak and trough of the channel are

called “limit up”and “limit down.”Limits can be daily

(interday, static) or intraday (dynamic). Some markets

are known to concurrently employ daily and intraday

limits. The earliest documented use of price limit was in

Dojima exchange in Japan in 18th century (West, 2000).

2.3 |Trading halt

Trading halt refers to a temporary suspension of continu-

ous trading for a single security, a group of securities, an

exchange, or a group of exchanges usually (but not

always;e.g., the EU) under the ambit of the same regula-

tor. It is used to redress—or in anticipation of—market

disorder; for example, impending corporate announce-

ment or news, or to remedy order imbalance. During a

halt, open orders can be cancelled, and options exercised.

Halts may be discretionary or rule‐based (automatic). For

the former, market operator exercises its discretion to halt

trading of a security to allow investors equal opportunity

to appraise news and make informed decisions on its

basis—typically ahead of important or relevant news. It

can also arise out of suspicion over irregular activity

regarding the asset's price. Rule‐based halts, contrarily,

SIFAT AND MOHAMAD 1131

are activated upon matching predetermined parameters.

For example, a stock's trading may be automatically

halted once a price limit is reached. These halts are tem-

porary in nature and easier to anticipate compared to dis-

cretionary halts, which allows participants to alter their

trading behaviour and strategy keeping in mind prospects

of trade stoppage since. Though rule‐based halts are more

common compared with discretionary halts, and shorter

in duration, exchanges can extend them at their

discretion.

2.4 |Volatility interruption

Unlike the circuit breakers popularized in North Amer-

ica, European exchanges began experimenting in the

1990s with a mechanism which suspends continuous

trading and switches to a call auction (or an extension

of call auction if interruption occurs during the auction)

if the next potential price falls beyond a predefined range

based on a reference price. This mechanism, volatility

interruption (VI), differs from traditional circuit breakers

in several ways. Firstly, VIs are not enforceable market‐

wide. Rather, they are enacted on individual securities.

This means triggering a VI only impacts that instrument

and not the whole market. Nonetheless, if the affected

security is a bellwether or industry leader, it can poten-

tially spillover, making unintended consequences.

Moreover, price discovery during a VI‐triggered auction

occurs via publishing auction prices and volumes. Lastly,

unlike halts which last for considerable amount of time

and sometimes for the whole trading day, VIs typically

last only a few minutes. In this way, VI can be argued

to be more conducive to derivatives pricing and index

calculations.

Figure 1 summarizes various forms of circuit breakers

employed around the world.

3|REGULATORY PRAXIS

Exchanges have experimented with circuit breaker mech-

anisms since the 1970s. However, the practice was dimin-

utive in scope and received little attention. Following the

Black Monday crash of 1987, the recommendation of

Brady Commission's 1988 Report catapulted the practice

to prominence, leading to greater adoption by exchanges

of asset‐specific and market‐wide variants. Most

exchanges set their own thresholds for halts and/or

limits. Halts can be sudden‐death (once triggered, trade

stops for the day/session;e.g., Kuala Lumpur Stock

Exchange in the 1990s) or progressive (multi‐tiered). An

example of a progressive halt mechanism is the NYSE:

If S&P falls by 7%, a Level 1 circuit breaker is triggered,

and the entire market's trade is halted for 15 min. Upon

resumption, a drop of 13% triggers second halt—also for

Circuit Breakers

Price Limits

Equity

Static

% Based Trigger

Price Based Trigger

Dynamic

% Based Trigger

Price Based Trigger

Derivatives

Contract-Specific

Exchange-Specific

Trading Halts

Single

Security

Regulatory

Exchange Triggered

News

Order Imbalance

Discretion

Market-wide Suddent-death

Progressive Tiered

Volatility

Interruptions

Static and Dynamic Limit

Triggers

Hybrid Limits / Halts / VIs

Course: Continuous Auction

Course: Discrete Auction

FIGURE 1 Types of circuit breakers in practice in exchanges around the world. The above image summarizes the various types of circuit

breakers currently in use by exchanges around the world. Although the choice of which mechanism to use remained quite simplistic at the

outset of regulatory experimentation, nowadays it is common to see a varieties of circuit breakers to be employed concurrently. This means

price limits and trading halts apply to the same securities, or a group of securities, or the market as a whole. The grey boxes indicate sources

and/or rationales for triggering the corresponding circuit breaker mechanism

1132 SIFAT AND MOHAMAD