Circuit Breakers Won't Work

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Although the exact details of last Thursday’s plunge of nearly 1000 points are still not quite clear, the SEC in meeting with various spokesmen of the six major exchanges concluded that a necessary solution to combating run-away program trading is by strengthening circuit breakers. Like the shut-off switches on old computers, circuit breakers were originally devised following the 1987 crash as a means of dealing with a stock market that had evolved into something no longer purely under the control of human beings.

So Why Won't They Work?

Actually, the real question is not why won't they work but why DIDN'T they work? That is, on May 6th, the day of the infamous "flash crash". Circuit breakers were already in what happened? Well, under current SEC rules there are three levels at which circuit breakers are triggered. The first one requires at least a drop of 10%. The others are 20 and 30% after that, as you can see from the table below:

Circuit breakers 

(Click image for larger view)

What’s interesting is that the market plunged on Thursday just under 10% AND right after 2:30, the cut-off time at which no intervention takes place until dropping to the second level that occurs at 20%. Quite a window of opportunity, I’d say…that is, if you knew how to play it. Had any circuit breakers been triggered, all orders would’ve been corrected or simply cancelled and any severe losses (or gains) would’ve been erased. However, since the market made such a wild swing without ever causing regulators to step in allowed for some extremely successful day trades, I’m sure! Imagine if you had a large short position on the market, or on carefully selected stocks? Both the NASDAQ and NYSE did cancel trades considered to be “erroneous” due to large price swings but they, of course, would have little to no authority over unaffiliated derivatives exchanges where even larger amounts of profit (or losses) were probably made.

A way the SEC could prevent such a similar drop, however, would be to merely implement stricter rules—say, trading halts for a 5 or 7.5% drop in the Dow, or having selectively placed trading halts on certain stocks. But, if the Dow or some stock is overvalued and corrects back down to where buyers roughly match sellers, then isn’t that a good thing? How much volatility should or shouldn’t we allow? If the SEC puts a downward limit of 5%, then don’t we also need an upward limit of equal amount? Otherwise, the market is rigged to just go up! How about dual-listed stocks? If US markets correct to a point where a trading halt is put in place, how will this rule be applied toward companies that trade on multiple and foreign exchanges where US regulators don’t have legal jurisdiction?

We’re All Connected Now

Of course, it wasn’t just our markets that tanked on Thursday. It was almost every other foreign exchange too. The fact that markets are becoming more and more interconnected via electronic exchanges is really just a parallel development of our modern world. This inescapable trend toward electronic convergence, as it may be called, has a very interesting consequence when thinking in terms of international finance: how do you contain or restrict trading activity to one place? For example, when the NYSE shut down their electronic trading unit on Thursday all market orders began flowing to the other exchanges, spilling out of their control. If the US decides to shut down our markets, how much of that will just flow over into the foreign exchanges? If a sufficient number of stocks are listed on a foreign exchange where the US has no jurisdiction, or where computer trading is done on an exchange having no physical location, who is responsible for regulation in these cases?

Certainly the stock prices of transnational corporations that trade over multiple exchanges would provide a timely investor with huge arbitrage opportunities if the US were to instantly pull liquidity from the market. And with trading programs poised like a finely-taut bow ready to fire off millions of orders at the sight of any mispricing, how do you expect a human regulatory body to react fast enough?

Can the System Really Be Turned Off?

What’s interesting is that our modern world markets—specifically the network of electronic exchanges –reflect, in many ways, the organic nature of the internet. And, although, it may be possible to turn off certain portions of the web, it is nearly impossible to fully shut the entire thing down given its sheer size and design. That this would present itself as a flaw to regulators when finding out that the kill-switch no longer works is quite ironic given the fact that the internet itself was designed for this very purpose—that is, to survive from being shut-off.

Really, when it comes down to it, circuit breakers may provide average investors with a small amount of protection when technology runs amok BUT it doesn’t do anything to fix the underlying vulnerabilities that currently exist. As for those, there are some major changes needed for the entire system…and that is clearly not going to happen overnight.

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About Cris Sheridan