Views on improving the integrity of global capital markets
06 May 2011

Duct Tape and Circuit Breakers

For those of us who were around back in 1987 (the year I received my CFA charter, I might add, boastfully), the circumstances of the “flash crash” of 6 May 2010 were in some ways a modern equivalent to the events of 19 October 1987. Back in 1987, it was a slow, steady draining from the market that lasted all day. Every time one looked at what was happening in the market, it was worse, sometimes much worse, than the last time. The events of a year ago are similar, just at the much faster pace of today, where we receive news from around the world in near real time and trade execution is measured in nanoseconds.

Stop-Gap Solutions

Aside from the official report that an unnamed buy-side firm (aka Waddell & Reed) launched the cascade with a seemingly innocuous $4 billion short derivatives position to hedge its long position in the cash securities market, the real question that everyone continues to ask is what caused it? Put another way, what have we learned in the intervening 365 days?

First, we have learned that the circuit breakers deployed after the crash do a good job of halting sell-offs, but they don’t prevent them. As The New York Times chronicled last autumn in this story, there have been a series of mini flash crashes since May 2010. In most cases, the price of a company’s shares suddenly, and inexplicably, falls off a cliff before the circuit breakers kick in and halt the slide.

One could say that these circuit breakers have done their job. In much the same way that circuit breakers in a home’s fuse box does their job, they prevent a serious failure. But, like a fuse box, if those circuit breakers keep tripping, you begin to recognize that you have a more serious wiring problem that needs repair.

The question is what is that fundamental “wiring” failure in the market? On the technical side, it is evidently momentary mismatches between buying and selling interests. More fundamentally, however, it is a function of the current market structure discouraging liquidity providers from placing limit orders as they have in the past. And they don’t because other market participants, hidden with the benefit of different market rules, step in front of their orders at the last nanosecond, leaving the limit order unfilled. The only time those limit orders do get filled, however, is when they are on the wrong side of the market — sort of a “heads I win/tails you lose” situation.

Curing the Symptoms

To this end, the SEC has proposed — and CFA Institute has supported — introduction of a “trade-at” rule. This rule would prevent those last nanosecond step-ins by requiring market participants to post a bid or offer for a certain amount of time prior to trading at that price, forcing these orders to the lit market, if only for a brief period.

Again, though, this solution is a stop-gap measure designed to cure the symptoms without fixing the underlying cause. And the underlying cause, as my colleague Rhodri Preece pointed out earlier this year in his study of the MiFID structure in Europe is a market structure that treats entities effectively doing the same thing — in this case, providing a multilateral trading venue for investors — differently. The different rules benefit some market players while tying other, more transparent entities down. Consequently, opaque brokers’ internalized crossing networks continue to gain market at the expense of lit markets, be they traditional exchanges or electronic communication networks, or ECNs.

Even if the SEC decided to do something about these fundamental weaknesses, it is unlikely they could, given the likelihood that those with interests vested in the status quo would use their influence with Congress to prevent it. We’ve seen similar efforts in the past.

In the meantime, we just have to hope that the SEC’s stop-gap measures work as intended. Otherwise, another major market failure is just one failed circuit breaker away.

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Image Credit: ©iStockphoto.com/Gregory_DUBUS

About the Author(s)
Jim Allen, CFA

Jim Allen, CFA, is head of Americas capital markets policy at CFA Institute. The capital markets group develops and promotes capital markets positions, policies, and standards.

1 thought on “Duct Tape and Circuit Breakers”

  1. Jim Thomas says:

    Thank you for sharing the article titled “Duct Tape and Circuit Breakers” on your website. As an AI language model, I’m here to provide you with a response.

    Your article explores an interesting analogy between duct tape and circuit breakers, highlighting the importance of circuit breakers in financial markets as a mechanism to prevent excessive volatility. Here are a few additional points to consider:

    1. Circuit Breakers and Market Stability: Expand on the role of circuit breakers in maintaining market stability. Discuss how circuit breakers help prevent extreme price fluctuations and promote orderly trading by temporarily halting trading activities during periods of significant market stress. Explain how they provide a pause for investors to assess market conditions and make informed decisions, thereby reducing the potential for panic selling or irrational trading behavior.

    2. Calibration and Effectiveness: Address the importance of calibrating circuit breakers to ensure their effectiveness. Explain how circuit breakers are designed to activate at specific thresholds, such as a certain percentage decline in an index, to trigger a temporary halt in trading. Discuss the ongoing evaluation and adjustment of circuit breaker mechanisms to strike a balance between preventing excessive volatility and maintaining market liquidity.

    3. Market Confidence and Investor Protection: Highlight the role of circuit breakers in promoting market confidence and investor protection. Discuss how the presence of circuit breakers reassures market participants that mechanisms are in place to address extreme market conditions. Emphasize how circuit breakers contribute to a fair and transparent trading environment, safeguarding investor interests and maintaining the overall integrity of the market.

    4. Market Evolution and Continuous Improvement: Discuss how circuit breakers have evolved over time in response to market dynamics and technological advancements. Highlight the adoption of circuit breakers in various financial markets worldwide and the lessons learned from past market disruptions. Address ongoing efforts to enhance circuit breaker mechanisms and incorporate new technologies to ensure their relevance and effectiveness in an evolving market landscape.

    5. Collaborative Approach: Emphasize the collaborative nature of implementing and maintaining circuit breakers. Discuss how exchanges, regulatory bodies, market participants, and other stakeholders work together to establish and fine-tune circuit breaker rules and procedures. Highlight the importance of coordination and communication among these entities to ensure a consistent and efficient response to market disruptions.

    By exploring the analogy between duct tape and circuit breakers, your article sheds light on the critical role circuit breakers play in maintaining market stability and protecting investors. It highlights the importance of ongoing evaluation, calibration, and collaboration to ensure the effectiveness of circuit breaker mechanisms in addressing market volatility.

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