Circuit breakers: Is there really an alternative?
Sylvain Thieullent, CEO of Horizon
Market volatility is back with a vengeance. We’ve not seen this level of trading activity since 1987 and it has presented fresh challenges to global markets. Back in 1987, the trading infrastructure failed to cope, and the collapse of equities overwhelmed the trading communication systems of the time, which caused outages and left orders unfinished.
In the case of this crash, you have to applaud how far market infrastructure has come. So far, trading systems have remained robust without significant shutdowns or outages aside from a few exceptions. Indeed, MiFID II will have played a role in this resilience considering, it enforced investment firms to test their algorithms and platforms for volatile market conditions.
In the midst of all the pricing turmoil, an unsung hero from recent weeks is the use of circuit breakers. Despite their simplicity, the measures have proven themselves to be fit for the modern era of trading after being triggered on some major exchanges twice in March. They were introduced after the 1987 crash to prevent markets going into freefall through a domino effect of panic selling. They do this by automatically halting trading when prices fall by a specific predetermined amount in one day – 7 per cent in these cases. It has sparked some debate about whether these are fit for purpose or indeed necessary but, without intervention, it could become an uncontrolled race to the bottom.
If anything, circuit breakers are more necessary now considering the growing use of algo trading and their role in market falls. It has long been held that algorithms play a role in trading crashes and they account for the vast majority of trading volume. Although they are sophisticated and intelligent, algos can only follow their predefined instructions and will react to the data they are being fed. If all indications point to sell, then sell they will. Therefore, with fewer human involvement of humans involved, circuit breakers are increasingly important to maintaining stability by giving the market time to breathe and relief to participants.
The system is not exactly popular and there are undeniable problems with it. The market is completely blind when they are activated, and the real stress comes when the markets reopen. There are winners and losers when a circuit is triggered, with orders left incomplete and people losing out on being on the right side of the swings.
However, it’s only for exceptional circumstances and, realistically, what is the alternative? It’s either that, or the market completely shuts down, as in the Philippines. But this is risky; if you shut it down and reopen after a few days or weeks, the value of the economy can be completely different, which makes reopening difficult – as demonstrated by the 24 per cent plunge in Philippine stocks.
Essentially, exchanges must continue to operate as the market adjusts to the new value of the businesses that the stocks represent; any intervention should only ever be to stop momentum to selling which might go beyond how the market truly values the stock. After all, the price will eventually level out to become an accurate representation of the business, even if that does mean it continues to go down.
The intervention is clearly useful and, from the perspective of the regulator and the exchange, it’s difficult to see what better methodology could be designed where everyone is in the same boat. A smarter system could be introduced, but whether it would be smoother is another matter. Smart usually means more complicated and why would you want to make it more complex? In a crisis, you do not want the extra layer of confusion caused by a technical system because people might not be clear on how it affects them.
Having said this, considering technology has completely transformed how trading operates, it is surprising that an alternative has not yet surfaced. When there is demand for a solution, the market will usually present one. Perhaps now is the time. Things rarely stay the same, particularly in such a fast moving and increasingly technical industry, so a new advanced system to stop excessive crashes seems likely in future.