Stock-Market Circuit Breakers
In the heat of last Monday's
stock-market dive, the New York Stock Exchange debuted circuit breakers.
Reviews of the procedure, which halts trading when the Dow Jones industrial
average drops dramatically, are mixed. Most traders say that the pauses
exacerbated the panic. Treasury Secretary Robert Rubin and others credit the
pauses with calming jittery investors. What are circuit breakers? Why were they
created? What is the evidence that they work?
Following
the October 1987 Black Monday stock-market crash , a presidential task
force was convened to investigate the crash's causes and suggest remedies that
would prevent a repeat performance. The task force blamed "faulty market
mechanisms ." The exchanges, it argued, lacked the infrastructure to
accommodate the trading volume that the drop occasioned: Phone lines clogged,
computers crashed, and printers jammed. Many orders simply weren't received.
Deluged traders couldn't match the buy and sell orders they had. The task force
recommended--and in 1989 the New York Stock Exchange implemented-- circuit
breakers , a pause in trading that would give buyers and sellers time to
assimilate incoming information and arrange transactions. Circuit breakers
afford investors and traders the time to sell stock calmly, rather than dump it
in a panic.
The main circuit breaker is an NYSE rule that
automatically stops trading for 30 minutes whenever the Dow Jones
industrial average tumbles 350 points from its previous day's close. Another
circuit breaker halts trading for an hour if the market drops another 200
points. The NASDAQ exchange, the American Stock Exchange, and the Chicago
Mercantile Exchange now stop trading whenever the NYSE stops. Also after 1987,
the exchanges agreed to curtail computer trading of futures when the Dow Jones
industrial average either gains or loses 50 points. This procedure is invoked
regularly.
Although circuit breakers
were first imposed this week, the governing board of the NYSE does stop trading
when circumstances warrant it. Following the 1987 market crash, for instance,
the NYSE shortened its hours to curtail panic trading. During the "paperwork
crisis " of 1968, the NYSE cut back hours for the first three months of the
year so that brokers could handle a massive backlog of unfilled orders. In
addition, specialists--the traders who handle the transactions of an individual
stock--are granted permission regularly by the NYSE to stop trading stock to
restore temporary imbalances between supply and demand. Bad weather,
presidential assassinations, and power outages all have resulted in the closing
of the market.
Most
foreign governments require local
exchanges to halt the trading
of stocks that have dropped drastically. Monday, markets in Tokyo, London, and
elsewhere prohibited the trading of specific stocks. No other country
automatically closes volatile markets for a breather.
Critics of the new rules say that circuit
breakers flopped in their NYSE debut. The first circuit breaker was thrown
at 2:35 p.m. Monday, Oct. 27. After the 30-minute pause, trading resumed and
the market dropped another 204 points in 25 minutes, triggering the second
circuit breaker . The current Wall Street consensus is that the break made
investors and traders even more inclined to sell, instead of cooling them off.
Many traders blame the cable networks , which dwelt on the first circuit
breaker and reported it as a sign of an impending crash. During the first lull,
traders who had orders to sell by the end of the day were already anticipating
a second circuit breaker. Fearing that a second circuit breaker would close the
market for the day and prevent them from executing their orders on advantageous
terms, they sold their stocks as soon as possible instead of waiting to find
the best price.
Circuit-breaker critics also argue that the mechanism prevents the
market from working itself out of a crash. Extreme volatility, they say, is a
natural part of the market's quest for equilibrium between supply and demand.
Interrupting this process causes additional drops such as Monday afternoon's,
rather than upswings such as Tuesday morning's.
Technology has made moot much of the
original justification for circuit breakers. Following the 1987 crash, both
NASDAQ and the NYSE invested billions in expanding and automating the
transaction infrastructure to accommodate the enormous swells in trading. The
NYSE's computers now can handle the sale of 2.7 billion shares a day, vs. 440
million in 1987. Monday, 685 million shares were traded--not much more than the
daily average volume of 528 million. But Tuesday, the NYSE handled a record 1.2
billion shares, with its central computer processing as many as 274
transactions a second. On both days, traders had no difficulty matching buyers
and sellers and speedily filling orders.
The Securities and Exchange
Commission and the NYSE originally devised the circuit breakers to kick in
after a 250-point drop. At the time, 250 points represented 12 percent of the
market's value. Adjusting for the quadrupling of the market over the last seven
years, the SEC and the NYSE raised the circuit-breaker trigger last year to 350
points. Critics say that 350-point trigger is far too low , allowing the
circuit breakers to flip at levels that don't warrant a stoppage of trade. They
appear to be right. Monday, when the first circuit breakers were imposed, the
market had dropped only 5 percent. SEC Commissioner Arthur Levitt Jr. has said
that the circuit breakers should be reformed so that they are triggered by a
drop in percentages, not points.
