Circuit Breakers and Market Runs 1

This paper analyzes whether the application of a circuit breaker to a nancial market (i.e. a mechanism that interrupts trading for a predetermined period when the price moves beyond a predetermined level) reaches its intended goals of increased market stability and overall welfare. Our framework of analysis is a model in which investors can trade at several dates and might face a liquidity shock forcing them to sell immediately when the shock occurs. This setting potentially induces a market run where investors commonly sell merely out of fear other investors are selling and not because they have current liquidity needs. We show that the introduction of a su¢ciently tightly-set circuit breaker within this setting successfully prevents this market run from occurring. Even more so, it could induce the socially optimal state (in which trading only takes place when it is motivated by liquidity needs) to arise. However, this desirable equilibrium can only be reached under particular economic conditions. When these conditions are not met, installing a circuit breaker might even lower social welfare as compared to a setting without a circuit breaker as it impedes socially desirable trades and stimulates socially undesirable trades. JEL Codes: D53, G01, G10, G18 Keywords: liquidity crisis, market stability, trading halt, high frequency trading, ash crash On May 6, 2010, at 2:32 p.m. a large mutual fund rm initiated an automated execution algorithm to aggressively sell a large index-futures position (valued at approximately $4.1 billion) as a hedge to an existing equity position. In the next few seconds, this action generated an unprecedented huge hot-potato volume e¤ect exposing the fragility of current-days nancial markets: still lacking su¢cient demand from fundamental buyers or cross-market arbitrageurs, high frequency traders were rapidly buying and reselling contracts to each other. Having launched a vicious liquidity spiral, the initial local non-informational event soon triggered broader contagion e¤ects causing equity markets to instantly dry up and indices to decrease by 5-6%. Twenty minutes later, however, these losses were in turn quickly recovered and the market had regained most of the drop. Quite aptly, this unprecedented sequence of events igniting a short-term liquidity crisis was labeled ash crash. Since then, discussions at the regulatory and market level reemerged globally in order to assess the appropriateness of so-called circuit breakers in preventing or alleviating such liquidity crises and their undesired consequences on market volatility and overall nancial stability. Circuit breakers were introduced after the global market crash of October 1987. Since then, they are a widely used technique in the stock market industry aiming at curbing and avoiding extreme price volatility and the resulting massive panic sell-o¤s. More speci cally, circuit breakers are mechanisms that monitor the market continuously and trigger a trading halt as soon as the price of an individual security or of an index goes (or is bound to go) beyond a predetermined level. This halt may be temporary or, under extreme circumstances, close the market before the normal end of the trading session. In essence, circuit breakers were designed to slow down the market in the event of a sharp market movement, and thus prevent trading from occurring at prices far o¤ fundamental values. As they arti cially impede any panic trading from taking place, circuit breakers give traders the time to properly analyze the true nature of the underlying shock inducing the initial signi cant price change, and help the market revert to equilibrium. Evidently, this is a desirable feature when the underlying shock is liquidity-driven (and the volatility is transitory). In this case, the circuit breaker protects the market from liquidity traders volatility-inducing trades, and protects the liquidity traders from trading losses that they will likely incur in times of poorly functioning markets. However, in case the underlying shock is informationdriven (with fundamental volatility), circuit breakers cause prices to adjust slowly to new information which imposes costs on the economy. In this case, a trading halt will merely postpone the inevitable and as prices are less informative while markets are closed and no one is certain of the new level, the uncertainty during the halt may See SEC (2010), Easley, Lopèz de Prado and OHara (2011), and Menkveld and Yueshen (2011) for an in-depth analysis. Stock prices accurately reecting all information about rms prospects indeed are essential for the proper allocation of available resources.