User:Mcclusk andr/sandbox

Circuit breakers are a financial regulatory instrument that were put in place to prevent stock market crashes from occurring. Since their inception, circuit breakers have been modified to prevent both speculative gains and dramatic losses within a small time frame. As a result of being triggered, circuit breakers either stop trading for a small amount of time or close trading early in order to allow accurate information to flow amongst market makers and for institutional traders to assess their positions and make rational decisions.

United States

Description

On the New York Stock Exchange (NYSE), one type of trading curb is referred to as a "circuit breaker." These limits were put in place after Black Monday in order to reduce market volatility and massive panic sell-offs, giving traders time to reconsider their transactions. The regulatory filing that makes circuit breakers mandatory on United States stock exchanges is SEC Rule 80B. It is there that the specifics of circuit breakers are elaborated, and the various price limits are outlined for investors to see.

The most recently updated amendment of rule 80B went into effect on April 8, 2013 and has three tiers of thresholds that have different protocols for halting trading and closing the markets.

At the start of each day, the NYSE sets three circuit breaker levels at levels of 7% (Level 1), 13% (Level 2), and 20% (Level 3). These thresholds are the percentage drops in value that the S&P 500 index would have to suffer in order for a trading halt to occur. Base price levels for which these thresholds will be applied are calculated daily based on the preceding trading day’s closing value of the S&P 500. Depending on the point drop that happens and the time of day when it happens, different actions occur automatically: Level 1 and Level 2 declines result in a 15-minute trading halt unless they occur after 3:25pm, when no trading halts apply. A Level 3 decline results in trading being suspended for the remainder of the day.

Circuit breakers are also in effect on the Chicago Mercantile Exchange (CME) and all subsidiary exchanges where the same thresholds that the NYSE has are applied to equity index futures trading. However, there is a CME specific price limit that prevents 5% increases and decreases in price during after hours trading. Base prices for which the percentage thresholds are applied are derived from the weighted average price on the future during the preceding trading day's last thirty seconds of trading. Price limits for equity index and foreign exchange futures are posted on the CME website at the close of each trading session.

There is a security specific circuit breaker system, similar to the market wide system, that is known as the “Limit Up - Limit Down Plan” (LULD). This LULD system succeeds the previous system which only prevented dramatic losses, but not speculative gains, in a short amount of time. This rule is in place to combat security specific volatility as opposed to market wide volatility. The thresholds for a trading halt on an individual security are as follows. Each percentage change in value has to occur within a 5 minute window in order for a trading halt to be enacted:

• 10% change in value of any security that is included in the S&P 500 index, the Russell 1000 index, and the Invesco PowerShares QQQ ETF.
• 30% change in value of any security that has a price equal to or greater than $1
• 50% change in value of any security that has a price less than $1

The previous trading day’s closing price is used to determine which price range a specific security falls into.

Founding

Following the stock market crash on October 19, 1987, sitting United States President Ronald Reagan assembled a Task Force on Market Mechanisms, known as the Brady Commission, to investigate the causes of the crash. The Brady Commission’s report had four main findings, one of of which stated that whatever regulatory agency was chosen to monitor equity markets should be responsible for designing and implementing price limit systems known as circuit breakers. The original intent of circuit breakers was not to prevent dramatic but fair price swings, rather to allow time for sufficient communication between traders and specialists. In the days leading up to the crash, price swings were dramatic but not crisis-like. However, on Black Monday the crash was caused by lack of information flow through the markets among other discrepancies such as lack of uniform margin trading rules across different markets.

Instances of Use

On October 27, 1997, under different trading curb rules then in effect, trading at the New York Stock Exchange was halted early after the Dow Jones Industrial Average declined by 550 points. This is the only time US stock markets have closed early due to trading curbs. Since then, circuit breakers have evolved from a DJIA points-based system into a percentage change system that tracks the S&P 500.

Many believe that this instance of use was unnecessary and that market price levels had increased so much since circuit breakers were implemented that the point based system triggered a halt for a decline that wasn't considered a crisis.

Effectiveness

Though the behind circuit breakers is to stop trading so that traders can take time to think and digest new information, there are a lot of tested theories that show trading volume actually increases as price levels approach a circuit breaker threshold, and trading after a halt completes lays the groundwork for even more volatile market conditions.

Magnet Effect

The Journal of Financial Markets has published work specific to the use of circuit breakers and their effects on market activity. Researchers have developed what is known as the “magnet effect”. This theory claims that the closer market levels come to a circuit breaker threshold, the more exacerbated the situation will become as traders will increase volume by unloading shares out of fear that they will be stuck in their positions if markets do stop trading.

Many believe there was an institutional bias to circuit breakers, as all of the large banks, hedge funds, and even some pension funds had designated floor traders on the floor of the NYSE who can continue trading while the markets are closed to the average investor. This argument is becoming less relevant over time as the use of floor traders diminishes, and the majority of trading is done by computer generated algorithms.

Price Discovery

Price discovery as it relates to equities is the process in which a security’s market value is determined by way of buyers and sellers agreeing on a price suitable enough for a transaction to take place. On the New York Stock Exchange alone, it is not uncommon for over $1.5 trillion of stocks to be traded in a single day.  Due to the large amount of transactions that take place every day, experienced traders and computer algorithms make trades based on the slightest upticks and down-ticks in price, and subtle changes in the bid-ask spread. When trading halts for any amount of time, the flow of information is reduced due to lack of market activity, adversely causing larger than normal bid-ask spreads which slows down the price discovery process. When stock specific trading halts occur in order for press releases to be announced, the market has to then make a very quick assessment of how the new information affects the value of the underlying asset leading to abnormal trading volume and volatility.