At its extreme, volatility in the stock market can be a deadly business. In some devastating episodes of the financial market’s history, some quite recent, fortunes have been wiped off in just a matter of days. There are several mechanisms that are triggered into action when market crashes unfold. One, in particular, is the stock circuit breaker which has a precise function to protect the overall stability of the market, in extraordinary times of distress.
In addition to being so important as a tool to protect investors, the stock circuit breaker is also critical for the well-being of the entire financial system, with all its institutions and functions. It acts as the frontline defense against adverse stock market behavior.
In this article, we delve into the stock circuit-breaking mechanism, highlighting its crucial significance as a protective defense system. Learning about this fascinating area would help enhance one’s understanding of the stock market and its dynamics.
What are Stock Market Circuit Breakers?
A stock market circuit breaker is a defensive mechanism triggered across a particular stock exchange that temporarily pauses trading when the overall market sees an abrupt decline in prices.
This breaking system works against irregular market volatility and attempts to counter market panic and bring about orderly trading. With the market halted for a short period, players can reconsider their impulses and act in a more informed way.
The stock circuit breaker is of two types, the first being a market-wide circuit breaker, and the other being a single stock breaker. The former comes into play for an entire stock exchange, whereas the latter is applied to individual stocks.
How Circuit Breakers Work?
Now that we have a general idea of what is a circuit in the stock market, we can take a more in-depth look into how exactly this works.
At its simplest, the circuit breaker mechanism is a simple trigger system that halts trading if a certain event takes place. This ‘event’ would typically be something like the S&P 500 index falling by a certain percentage in a defined time period.
The duration for which trading is halted, either for an entire exchange or for individual security would depend on the severity of its price crash. It can range from a 15-minute pause to that of the remainder of the day.
The duration of the halt is also referred to as the cool-off period, as it aims to ensure a subsiding of market panic. During this cool-off, market players can still place trade orders that will be queued and executed upon trade being resumed.
History of Circuit Breakers
Upon rewinding the clock, and turning to history to see the origins of the stock circuit breaker, we find that there is much insight to be gathered, about the attempts of regulators to ensure market stability and prevent panic.
The stock market circuit breaker came as a response to one of the most devastating market crashes in October 1987, which came to be infamously called Black Monday. During the day, the Dow Jones index underwent the hardest single-day decline of 22.6%.
The Security and Exchanges Commission worked in collaboration with the stock exchanges operating across the country to develop a safety system to prevent future crashes from playing out in a similar manner and was implemented by 1988.
Amendments were later made to the system by regulators in 1996 and 2013, involving changes in the specific trigger points for each breaker level. The current working circuit breaker system is the product of decades of enhancement and specialization.
Criticism of Circuit Breakers
Despite their usefulness as a first line of defense against market crashes, and as tools to ensure financial stability, stock circuit breakers are often the target of scathing criticism by those who oppose it. Some of these criticisms are as follows:
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Worsening Panic
Many rightfully point out that the triggering of a stock circuit breaker is usually a greater cause of panic than the event that sets it off.
The abrupt halt of trading creates uncertainty throughout the market, with many assuming the worst, and coming up with crisis strategies during the cool-off period.
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Questionable Effectiveness
Certain critics state that a temporary halt of trading is hardly an effective way to avert a market crash, and would only delay the inevitable.
This criticism is based on the idea that none of the fundamental factors leading to the crash are addressed, and a mere trading pause would resolve each of those. It would be akin to putting a band-aid on a bullet wound.
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Can Be Tools For Manipulation
One of the most scathing criticisms laid against stock circuit breakers is the manner in which they can be gamed and exploited.
It is hypothetically possible for big market fish to cause an artificial crash to trigger a circuit breaker. This could play out similar to a bear market trap, but with the intention of setting off the circuit breaker.
In the resulting trading halt, the engineers behind the crash would pile up on buy orders which would result in massive gains from the price rebounds.
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Results In Mispricing
Many also criticize stock circuit breakers as causing inefficiency in the market, which subsequently results in the mispricing of shares. The reason for this is the delay it brings by abruptly halting trade.
When traders do not have real-time data and securities are priced on outdated information, there is a significant market inefficiency.
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Arbitrary Trigger Levels
The way stock circuit breakers work is by setting off after an event takes place based on an arbitrary shift, for instance, a 7% drop in the S&P 500.
This arbitrary drop may not necessarily actually indicate panic in the market and could be a normal reaction to new information. Many have called for a more dynamic and systematic approach to circuit breaking.
Real-World Example of a Circuit Breaker
In order to contextualize the stock market circuit breaker concept, we need not look further than Turkey in the midst of one of the worst earthquakes it had suffered in its history.
As news of the scale of the earthquake spread across the nation, and the extent of the casualties began coming to light, the Borsa Istanbul Stock Exchange (BIST) experienced a hard sell-off, resulting in a single-day plunge of over 20%.
In the ensuing market panic, close to $35 billion had been wiped off the exchange, and an immediate circuit breaker was triggered on the 8th of February and lasted until the 14th of February. The move was said to protect investors from further capital loss.
It must be noted, however, that when trading did resume the following week, the stock market showed a remarkable improvement of over 9% due to relief policies announced by the Turkish government involving share buybacks.
When Is a Market-Wide Circuit Breaker Triggered?
Market-wide circuit breakers are usually triggered when certain events take place that impacts the volatility and share price of an entire market, rather than a particular stock, as in the case of the Turkish stock exchange halt described above.
In American stock exchanges, the trigger level for a circuit market breaker is a 7% drop of the wider market, as represented by the S&P 500 index. This took place after the outbreak of the Covid-19 pandemic, in March 2020.
These market-wide circuit breakers usually take place in addition to individual stock circuit breakers. A classic example of such a phenomenon is Halliburton Co (NYSE: HAL), which experienced three circuit breakers in a single hour when trade opened.
The first was the market-wide trigger which halted trade across the exchange for 15 minutes, whereas the remaining breakers came about after HAL experienced strong price plunges.
What Happens At Each Breaker Level Threshold?
The way stock circuit breakers work is through specified threshold levels, with each reflecting the severity of the fall of a stock price or the wider market. These levels go on to determine how long the cool-off period should be with trading halted.
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Level I
Normally, the level I threshold takes place when the S&P 500 index goes through a drop of at least 7% in a single trade session, before 3:25 pm ET. At this level, trading is ceased for 15 minutes.
If the fall takes place after 3:25, pausing trade would not be necessary as the session is already approaching its close.
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Level II
If the S&P 500 index continues its fall beyond the level I threshold and drops by 13% before 3:25 pm ET, the level II circuit breaker would be triggered. This would bring an additional 15-minute pause to trading.
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Level III
The Level III threshold is considered to be the most serious and indicates a vicious market crash.
This is triggered when the S&P 500 index undergoes a 20% fall in a single day (at any time of the day), resulting in the halting of trade for the rest of the day.
Are the Rules the Same for Single Stock Circuit Breaker?
Single stock circuit breaker rules and the market-wide circuit breaker rules are quite distinct, as each phenomenon has different implications for investors. The following are the most important differences:
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Scope
Single-stock circuit breakers cover individual stocks while overlooking the behavior of the wider market, whereas market-wide circuit breakers have a broader view of the entire stock market.
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Threshold Range
The threshold for single-stock circuit breakers is a lot wider than those of the entire market, as sharp plunges for individual stocks are not as alarming a phenomenon as an entire market crash.
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Duration
The cool-off period with single-stock circuit breakers is typically narrow and can be as low as 5 minutes, whereas, for market circuit breakers, these could go on for an hour or an entire day, if the drop is severe enough.
Effects On Trading Volume And Stock Prices
Depending on the type of circuit breaker, and the circumstances that set it off, the effects can immediately be felt by observers.
The first impact is on trade volume, which immediately falls to zero in real-time, as trading activity is suspended temporarily. This further reduces liquidity in the market. Both volume and liquidity can potentially rebound after the cool-off period.
Similarly, circuit breakers can potentially stabilize fast-falling prices as the market gains a clear picture of the unfolding circumstances. In certain cases, however, price falls can be exacerbated when the event is deemed as being catastrophic.
Conclusion
The stock circuit breaker is a useful mechanism that was developed for the market to slam the brakes when it slips toward a crash. This financial device was introduced to protect investors and ensure the stability of the market and all financial institutions.
Stock circuit breakers have been set off a number of times, giving panic-stricken market players the breathing room to determine the best way forward. The mechanism has allowed stock exchanges across the world to survive the most devastating catastrophes.
Despite their utility, circuit breakers in the stock market have been heavily criticized by certain circles as being arbitrary, ineffective, and prone to manipulation.
Stock circuit breakers are a powerful tool currently deployed across entire markets and for individual stocks. It is widely accepted in the mainstream as the first line of defense of the financial world.
FAQs
Are Options Markets Also Halted When a Circuit Breaker Is Triggered?
Yes, options markets are also halted with a circuit breaker trigger, as the underlying assets, which are stocks, have their spot prices at a standstill for the specified duration, based on the threshold.
Can Stock Circuit Breaker Prevent A Stock Market Crash?
Yes, stock circuit breakers can generally prevent market crashes by allowing price stability in the market after a cool-off period. However, they are not always guaranteed to work, and could merely delay crashes in the event of a serious catastrophe.
What Triggers A Stock Circuit Breaker, And How Often Do They Occur?
An extraordinarily sharp fall in prices usually triggers a stock circuit breaker, based on predetermined threshold levels. Level I threshold triggers can occur a few times each year, whereas level III threshold triggers take place once every several years
