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From: Robert Spira
Time: 10:07:02 AM
Hey Buddy, you have a great big point and I don't think that there is any point in arguing with you. I think though, that the circuit breaker theory is based on the great good for the majority and is used more than anything to prevent major economic dislocations.
In 1987 when the market tanked, securities couldn't be traded, orders couldn't be placed, trades couldn't be cleared and markets throughout the world crashed in sympathy. Part of the problem has been corrected in that The Exchange can now accommodate volume very substantially greater than it could at that time. In addition with a shorted clearance schedule in effect, trades don't have a tendency of aging and then becoming difficult to clear. I think that the circuit breaker allows everyone a chance to catch their collective breath's and with time on their side determine the proper course of action. An example of this would be; what if you were bottom fishing for stocks and the market broke but you didn't know about it. The extra time may have given you an opportunity to pick up bargains as opposed to keeping you from doing it. All in all, it appears to work for most of the people. Because of the constant tinkering with the circuit breaker system we though it would be a good idea to include a scholarly work on the subject by Roberta Karmel, a Director of the New York Stock Exchange, former SEC Commissioner and well know securities attorney at Kelley Drye & Warren LLP.
What Is the Point of Circuit Breakers?
Roberta S. Karmel New York Law Journal April 16, 1998
CIRCUIT BREAKERS, or automatic trading halts triggered by market declines, were first adopted by the New York Stock Exchange Inc. (NYSE) and other equity markets in 1988. They had been recommended by a Presidential Task Force in the aftermath of the stock market crash of Oct. 19, 1987, when the Dow Jones Industrial Average fell 508 points, or 22.7 percent. These circuit breakers were not triggered until a decade later, on Oct. 27, 1997, when the Dow fell 554 points. Unfortunately, the circuit breakers had by then become out-of-date. Although the Oct. 27 drop of 554 points was the largest single-day point drop in the Dow's history, it was only a 7.2 percent decline, one-third of the severity of Oct. 19, 1987. More important, the exercise of the circuit breakers seemed to cause more problems than it solved.
The NYSE has now proposed new, more finely calibrated circuit breakers designed to halt the market only under very extreme circumstances. While circuit breakers have been justified in part as a mechanism to protect individual investors, that rationale is debatable, and a discussion of exactly what they are supposed to achieve has been minimal. This column will explain what circuit breakers have been in effect for the past 10 years and how the NYSE proposes to change them, and it will inquire whether closing the market is an appropriate response to severe price declines.
From Oct. 13, 1987, to Oct. 19, 1987, the Dow fell 769 points, or 31 percent.1 This decline was viewed as a serious threat to public confidence, possibly a stock market crash as serious as that of Oct. 29, 1929, that would be followed by a downturn in the economy caused by a lack of confidence.2 A high-level Presidential Task Force was appointed to analyze the causes of the crash and make appropriate recommendations.3 Studies by the Securities and Exchange Commission (SEC) and the NYSE, among others, also were generated,4 and congressional hearings were held.5
A perspicacious observer suggested that "the reason we had a decline and such a sudden decline is -- the unprecedented heights or the overvaluation of stock, the highest in history."6 However, most government and other studies of the crash focused on the market mechanisms that drove prices down and made recommendations for curbing price volatility and aggressive selling during market declines. Further, much of the post-mortem discussion of the October 1987 crash fingered portfolio insurance and program trading as the culprits in the market break.
One of the Brady Report's recommendations was that circuit breakers should be imposed on all financial markets. This recommendation stemmed from the Brady Report's conclusion that the market for stocks, stock index futures and stock index options had become "one market" and that, therefore, coordinated trading halts should be formulated to protect that market. The Brady Report expressed the view that coordinated circuit breakers would have three benefits that would cushion the impact of market movements and protect investors and markets.7
First, they would "limit credit risks and loss of financial confidence by providing a 'time-out' amid frenetic trading to settle up and insure that everyone is solvent."8 Second, they would facilitate price discovery by giving market players time to evaluate and publicize order imbalances "to attract value players to cushion violent price movements."9 Finally, they would "counter the illusion of liquidity" by formalizing the fact "that markets have a limited capacity to absorb massive one-sided volume."10
The circuit breaker concept came from the commodity futures markets. Before 1988, price limits were used for many futures contracts, although not stock index futures.11 The price of a futures contact subject to a daily limit is permitted to rise or fall only within a prescribed range from the previous day's settlement price. The market does not close when price limits are reached. Rather, trades cannot be made at a price above the upper limit or below the lower limit.12 The Brady Report recommendation that system-wide trading halts be imposed across stock and futures markets was novel and more drastic.
The Brady Report's general recommendation regarding circuit breakers was given shape by the recommendation of the Working Group on Financial markets, created by Executive Order to facilitate coordination among financial regulators concerning intermarket issues.13 Specifically, the Working Group recommended that all U.S. markets for equity and equity-related products halt trading for one hour if the Dow declined 250 points from its previous day's closing level.14 Further, if upon reopening, the Dow declined 400 points below the previous day's close, trading should halt for two hours.15 In designing these procedures, the Working Group focused on market events that were so dramatic as to trigger ad hoc and destabilizing market closings.16
Not all observers agreed that circuit breakers were a desirable response to the 1987 market break. Artificial constraints prevent investors from engaging in equity transactions that reflect their assessments of economic events. Hence, price limits and trading halts may impair the ability of stock market pricing mechanisms to allocate capital resources efficiently.17
Further, as a Committee of Inquiry appointed by the Chicago Mercantile Exchange pointed out, the existence of pre-announced artificial limits, which constrict continuous trading may accelerate price movements toward that limit. Price movements toward the boundary assure that the boundary will be reached.18 Also, circuit breakers could cause trading to migrate overseas. Further, as this author pointed out in a column written soon after Working Group's Report, circuit breakers could have other deleterious effects. Large traders intent on effecting sales may trade off exchange among themselves, but small investors could have greater difficulty selling shares and therefore could be trapped in their positions.19
Another critic of the circuit breaker idea who was then
president of the American Stock Exchange expressed the view that circuit breakers should not be tripped to control volatility, but rather to ease the difficulties involving liquidity and investor access to the markets.20
Despite these and other criticisms of the circuit breaker concept, endorsement of circuit breakers by the Working Group made their adoption a foregone conclusion. One year after the 1987 crash the NYSE put into effect as Rule 80B the circuit breakers recommended by the Working Group so that trading would be halted for one hour if the Dow fell 250 points and for two hours if the Dow fell another 150 points on the same day.
Parallel rules were adopted by other securities markets and by the futures markers that trade stock index futures contracts.21 A decade later these levels were increased and the duration of the trading halts were shortened to half an hour for a 350-point drop and one hour for a 550-point drop on the same day.22 SEC approval of these new circuit breakers provided that they would expire on Jan. 31, 1998.23
Because many of the studies of the Oct. 19, 1987, market break blamed program trading for creating undue market volatility, Rule 80A of the NYSE was put into effect to compliment Rule 80B. Rule 80A was the so-called "sidecar" provision triggered by a 12-point decline in the S&P 500 Stock Price Index futures contract (S&P) (about equivalent to a 96-point drop in the Dow). After such a decline, orders for all listed S&P stocks entered through the NYSE's automated order routing system are held in a special file for five minutes. Then, buy and sell orders are paired, and any imbalance is given to the specialist for execution. Further, stop limit orders are prohibited under most circumstances.24
In 1990 the SEC approved amendments to NYSE Rule 80A following a period of turbulent markets related to the escalation of tensions in the Mideast. These amendments instituted a tick test in response to concerns that index arbitrage activity was aggravating large market-wide swings.25
Under amended Rule 80A, when the Dow index moves up 50 points or more from the previous day's close, index arbitrage orders in any component stock of the S&P must be executed on a "buy-minus tick" (a price below the last sale price), and when the Dow drops 50 points or more, index arbitrage orders must be executed on a "sell-plus tick" (a price above the last sale). When the Dow returns to a level 25 points or less away from the previous day's close these restrictions are removed.26
Circuit breakers were tested in the market plunge of Oct. 27, 1997, that occurred in response to turmoil in the Asian financial markets. A trading halt was triggered by a 350-point drop in the Dow at 2:35 p.m. EST, which ended at 3:05 p.m. Then the Dow plunged another 200 points, triggering another halt at 3:30 p.m. EST and closing the market for the day.27 The next day the Dow rose 337 points on record volume of 1.2 billion shares.28 Although the NYSE was praised for handling the chaotic trading and the high volume of Oct. 27-28, 1997, criticisms of circuit breakers were immediate.29
These criticisms were related but did not necessarily question whether circuit breakers were needed at all. Many criticized the existing trigger points. The Oct. 27, 1997, halts were triggered by market declines that in terms of percentage were much lower (7.2 percent) than the Oct. 19, 1987, market crash (22.7 percent). In addition, when the second halt closed the market it deprived investors of the ability to trade and value stocks at the close. Finally, the second circuit breaker worked almost as a "bull's eye" for traders and investors, possibly accelerating the plunge as market players scrambled to sell before the shut-down point.30
In response, the NYSE reached a tentative agreement with other markets to allow stocks to plunge 10 percent before triggering circuit breakers, but the NASD suggested that markets shut down for the day only if the market drops a full 20 percent after 2:30 p.m.31 Criticisms of the exercise of circuit breakers quickly led to congressional hearings at which the chairman of the SEC testified against existing circuit breakers and urged that any amendments should be designed to ensure that the exchanges are open at the end of the day.32
While these hearings were in progress the SEC approved a temporary modification of the NYSE's circuit breaker rules, effective from Feb. 1 until April 30, 1998.33 These modifications establish four different NYSE trading halts. If, before 3 p.m., the Dow falls 350 points from the previous day's close, trading will halt for 30 minutes. But if at 3 p.m. or later, the Dow falls 350 points, trading will not halt unless the fall continues to 550 points. If before 2 p.m. the Dow falls 550 points from the previous day's close, trading will halt for the day. The NASD and all other U.S. equity and equity-related markets agreed to a coordinated trading halt under these circumstances.34
New Circuit Breakers
At its February meeting, the NYSE board approved new circuit breakers based on a concept of percentage drops rather than point drops. Under the new proposal, a 10 percent drop in the Dow would halt trading for one hour if it occurred before 2 p.m. and for 30 minutes if it occurred from 2 to 2:30 p.m., but would not halt trading after 2:30 p.m. A 20 percent drop occurring before 1 p.m. would halt trading for two hours and from 1 p.m. to 2 p.m. for one hour and close the market for the day after 2 p.m. A 30 percent drop would close the market for the day whenever it occurred.35
The actual point levels involved would be fixed quarterly based on the level of the Dow in the previous month.36 The NYSE obtained the blessing of the SEC chairman before it was announced,37 and it was quickly approved by the SEC, effective yesterday. Now that these changes are approved, the NYSE will consider widening its "collars" that limit program trading when the Dow rises or falls 50 points.38
Circuit breakers are not likely to protect the small investor. Indeed, they could induce panic and uncertainty if the markets shut down suddenly and unexpectedly.39 Rather, circuit breakers have a threefold purpose. They can allow financial institutions and regulators time to assess legitimate concerns about creditworthiness in a market plunge. They can provide a respite for all investors to contemplate "fundamentals" and halt an unwarranted further decline due to panic selling and a lack of buyers. They can relieve NYSE specialists of an unrealistic obligation to continue to buy stock when there are no other buyers in the market.40
During the panic of 1907, J. Pierpont Morgan personally arranged a $25 million bankers' fund to support prices, ending the panic and saving the NYSE.41 In October 1987 a proposal to create a $1 billion superfund with capital advanced by member firms to help traders designated by the exchange to maintain fair and orderly markets in their assigned stocks died a swift death.42 Instead, the Federal Reserve Board flooded the market with liquidity, trading in individual stocks in the Dow was halted, the Chicago Mercantile Exchange suspended trading in the S&P index, and stock purchases by major U.S. corporations were encouraged by the White House Chief of Staff.43
The Dow is at far loftier heights today than it was in 1987 and a concerted buying program to put a floor on a stock market crash would presumably be that much more difficult and costly to orchestrate. Further, the capital of all specialists firms combined is minuscule compared to the amount of assets under management by institutional investors, but only specialists have affirmative obligations to buy stocks when the Dow is plummeting to keep the markets in their speciality stocks fair and orderly.
Stock market crashes are caused by unwarranted and overly exuberant investor expectations leading to unjustified run-ups in stock market prices. When reality looms and psychological expectations shift, a sudden market break leads to a selling panic. But no regulator wants to play Cassandra, predict calamity and call an end to a bull market.44
When the next crash comes, circuit breakers may temporarily halt the decline and perhaps prevent widespread bankruptcies of specialist firms and other financial intermediaries, but circuit breakers cannot create the buying power necessary to turn a selling panic around. Further, in today's markets, that buying power can probably only come from institutional investors who have no general obligations to the marketplace.
(1) Report of the Presidential Task Force on Market Mechanisms, Fed. Sec. L. Rep. (CCH) Special Report No. 1267, Jan. 12, 1988 at 1 (Brady Report).
(2) Tim Metz, Black Monday 154-55 (1988) (Metz).
(3) Brady Report, note 1 supra.
(4) SEC Staff Report, "The October 1987 Market Break," Fed. Sec. L. Rep. (CCH) Special Report No. 1271, Feb. 9, 1988; Nicholas DeB. Katzenbach, "An Overview of Program Trading and Its Impact on Current Market Practices," Dec. 21, 1987. See Lewis D. Solomon & Howard B. Dicker, "The Crash of 1987: A Legal and Public Policy Analysis," 57 Fordham L. Rev. 191, 191-92 (1988).
(5) "Black Monday," The Stock Market Crash of October 19, 1987, Hearings Before Sen. Comm. On Banking, Housing, and Urban Affairs, S. Rep. 100-649 (1988).
(6) Id. at 279 (Testimony of Leo Melamed).
(7) Brady Report note 1 supra at 66.
(11) Solomon & Dicker, note 4 supra at 236.
(13) See Interim Report of the Working Group on Financial Markets, May 1988. Members of the Working Group were the Under Secretary of Finance, Department of the Treasury and the Chairman of the CFTC, Federal Reserve Board and SEC.
(14) Id. at 4 and App. A.
(17) Solomon & Dicker, note 4 supra at 237.
(18) M. Miller, J. Hawke, Jr., B. Malkeil and M. Scholes, "Preliminary Report of the Committee of Inquiry Appointed by the Chicago Mercantile Exchange to Examine the Events Surrounding October 19, 1987" (Dec. 22, 1987) at 51.
(19) Roberta S. Karmel, Why "Circuit Breakers" Will Backfire, New York Times, May 18, 1988, at 23.
(20) Kenneth R. Leibler, "Circuit Breakers a la Brady Treat Only the Symptom," Wall Street Journal, June 8, 1988, at 24.
(21) Testimony of James L. Cochrane, Sr., Vice-President and Chief Economist, NYSE, on Trading Halts and Program Trading Restrictions to the Sen. Subcomm. On Banking, Housing and Urban Affairs, Jan. 29, 1998 at 5 (Cochrane).
(22) See Exchange Act Rel. No. 38221, (Jan. 31, 1997), 62 Fed. Reg. 5871 (Feb. 7, 1997).
(24) Cochrane, note 21 supra at 12-13.
(25) See Exchange Act Rel. No. 28282 (July 30, 1990). The rule was approved on a pilot basis but thereafter received permanent approval. Exchange Act Rel. No. 29854 (Oct. 24, 1991).
(26) See Cochrane, note 21 supra at 13-14.
(27) Anita Raghavan & Greg Ip, "Market Officials, SEC to meet to Decide Whether 'Circuit Breakers' are Faulty," WSJ, Nov. 19, 1997, at C-1.
(28) "Record Market Drop Trips Circuit Breakers; Next Day Sees New Trading Volume Record," Sec. Reg. & L. Rpt. (BNA), Oct. 31, 1997 at 1510.
(29) Raghavan & Ip., note 27 supra.
(30) Id. See also Deborah Lohse, "g Board Agrees to Let Stocks Fall 10 percent Before Triggering Its Circuit Breakers," WSJ, Jan. 27, 1998, at C-11.
(32) Paul Beckett, "SEC's Levitt Calls Big Board Proposals To Alter Trading-Halt Triggers Flawed," WSJ, Jan. 30, 1998, at B-7E.
(33) Exchange Act Rel. No. 39582 (Jan. 26, 1998).
(34) NASD Notice to Members 98-26 (Feb. 1998).
(35) See Exchange Act Rel. No. 39666 (Feb. 13, 1998).
(37) Greg Ip., "Big Board Shifts Plan on Closing," WSJ, Feb. 6, 1998 at C-1.
(39) See Holman W. Jenkins Jr., "Why Circuit Breakers? Hint: Not for the Little Guy," WSJ, Feb. 4, 1998 at A-23.
(41) Metz, note 2 supra at 37.
(42) Id. at 10.
(43) Id. at 160-61, 195, 212-14, 234. It is noteworthy that the NYSE's current circuit breaker proposal requests that the SEC suspend its rule 10b-18, 17 CFR �240.10b-18 (1998), governing buy-back programs of corporations in the event of a market break. See Exchange Act Rel. No. 39666 (Feb. 13, 1998).
(44) To his credit, John Phelan, then chairman of the NYSE predicted a financial "meltdown" in late 1986 and thereafter but NYSE member firms engaged in program trading were disinclined to listen to these warnings. See Metz, note 2 supra at 45.