Circuit breakers

U.S. regulators are now also looking to overhaul the original crash-avoidance tool, the marketwide circuit breaker, which halts trading for a given period when the market drops by a specified amount. The proposed changes would mean that the circuit breakers are triggered earlier but will generate shorter trading halts.

The existing circuit breakers weren’t triggered by the Flash Crash. In fact, they’ve been triggered only once since they were adopted almost 25 years ago. So, regulators are looking to create a more relevant market speed limit.

Indeed, in the wake of the Flash Crash, regulators in both Canada and the U.S. suggested that the existing marketwide circuit breakers would have to be reassessed. Now, the various national securities exchanges and the industry self-regulatory organization, the Financial Industry Regulatory Authority, in the U.S. are proposing to overhaul their circuit breakers.

If the U.S. securities regulators go ahead with these proposed changes to their circuit breakers, Canadian regulators may well follow suit.

Specifically, the U.S. proposals would reduce the thresholds necessary to trigger various types of halts, market declines of 10%, 20%, and 30% will change to 7%, 13%, and 20%, respectively. Among other things, the proposals also would shorten the resulting trading halts that do not close the market for the day; change the index used to determine a trigger to the S&P 500 composite index from the Dow Jones industrial average; and move to recalibrating the trigger thresholds daily rather than quarterly.

In its proposal, FINRA says it believes these changes “will provide for a more meaningful measure … of when to halt stocks on a marketwide basis as a result of rapid market declines,” given the faster, electronic markets that prevail today. The FINRA proposal adds that the Flash Crash had demonstrated that a 10% decline may be too high a bar for determining whether to halt trading.

By also reducing the duration of halts, the U.S. SROs are aiming to minimize the disruption caused by a halt, allowing trading to resume more quickly. FINRA’s proposal says that the regulator and the other SROs believe that “in today’s markets, where trading information may travel at a speed of microseconds, a 15-minute trading halt … strikes the appropriate balance between halting trading for market participants to assess the market and minimizing the time needed for an effective halt.”

And the proposed shift to the S&P 500 composite index from the DJIA is designed to link the trigger for a market halt to a broader market measure.

The existing Canadian circuit breakers are already geared toward the U.S. market, given the large amount of interlisted trading — except on days when the Canadian market is open and U.S. markets are closed. In those situations, Canadian circuit breakers can be triggered by 10%, 20% and 30% declines in the S&P/TSX composite index.

The Investment Industry Regulatory Organization of Canada’s review of the Flash Crash has concluded that the Canadian regulators should consider whether to revise the trigger levels for the existing circuit breakers, and whether a Canadian-based circuit breaker level is required. But, so far, IIROC hasn’t proposed any reforms of its own. For now, Canadian regulators are watching what happens with the proposed U.S. reforms.

 

“We are reviewing the proposed changes with interest and will closely monitor the responses,” says Lucy Becker, vice president, public affairs, at IIROC. “Our position remains that we would wait to see what, if any, changes the U.S. proceeds to implement and analyze them to see if they would continue to be appropriate for the Canadian market.”

Indeed, it seems likely the U.S. changes will go ahead. The U.S. securities industry lobby group, the Securities Industry and Financial Markets Association, has come out in favour of the proposed changes, saying that it’s “critical” to update the existing circuit breakers to make them “work more appropriately in today’s trading environment,” given that they weren’t triggered at all by the Flash Crash.

Yet, while tweaking the existing circuit breakers to make them more effective in modern markets may be helpful, in future, regulators may be able to call on even more sophisticated tools to calm trading.

Some new research from computer scientists at the Lawrence Berkeley National Laboratory in Berkeley, Calif., suggests that supercomputing techniques could give regulators the ability to anticipate these sorts of crashes before they happen, enabling them to slow markets rather than halting them entirely. The research found that a couple of indicators — an indicator developed by researchers at Cornell University to measure order-flow imbalances, and a measure of market fragmentation — could serve as “early-warning signals of unusual activities.”

The study found that these indicators rose strongly in specific stocks that were at the centre of the Flash Crash about an hour before the crash hit. The researchers concluded that the existing circuit breakers “are very ‘blunt instruments’ that do not allow the market to self-correct and stabilize, and they can easily make a bad situation worse. Our tests showed that [these] indicators could provide early-warning signals for a more gradual ‘slow down rather than stop’ replacement for on/off circuit breakers.

“This is a preliminary step,” the report concludes, “toward a full-fledged early-warning system for unusual market conditions.”            IE