Revisiting Circuit Breakers After Black Monday: Reasonable or Ridiculous?

Like any journalist sitting by observantly as global markets quake — as they did to varying extents this Monday — one of my favorite pastimes is to wait for the very first fintech analysis and commentary (as well as pitches from our friends at PR companies) to flow into my inbox. It adds to the excitement.

Now, besides a roundup of the sell side's one-liner prognostications about what happened (doesn't count!), the 'fastest-to-email' gold star this time went to Tabb Group at 2:18 EST — and to their credit, they're often first to the punch with some initial thoughts and data to debate.

In this case, Tabb analyst Luther Zhao pointed out that the circuit breakers put in place for CME's equity index futures after the 2010 Flash Crash had been triggered multiple times Monday morning, causing several trading 'time outs' once prices had dropped 5 percent (overnight) and 7 percent, respectively.

The same, he pointed out, happened for the Dow and Nasdaq under their procedures. And, to underscore that point, the WSJ reported last night that more than 1,200 stocks and ETFs were paused at some point under similar exchange rules.

It's like an entire apartment building had their vacuum machines running at once — with all of them plugged into the same outlet.

Zhao surmised that authorities would want to revisit these mechanisms once markets stabilize, arguing that the circuit breakers appeared to do little in staunching a steep decline in prices as liquidity — passive liquidity, especially — disappeared in these indexes both before and during the hour after markets opened.

What Constitutes Success?

So far as technology problems go, circuit breakers are pretty easy — on a technical level, I haven't seen or heard any complaints about their activation in this instance. The debate here, especially for the buy side, is more philosophical: how much interventionary activity into trading is appropriate? And is it even effective?

To start with, let's go to the extreme. Many smart minds out there are now arguing that China's aggressive intervention into its markets recently has shaken foreign investor confidence in the country's willingness to let a free market do its thing. Some say that this worsened Monday's sell-off.

Even if the Chinese government's intervention was improvised, rather than automated, and driven by larger economic issues, it looks and acts a lot like a circuit breaker — lasting longer and enacted more haphazardly, yes, but the same basic theory applies: don't let people flee the market as quickly as they'd like to.

Indeed, halting trading, whether for five minutes or hours or days, doesn't always have the desired effect of stability. And we've seen that argument regularly made in the past and closer to home, too — after the Knight Capital meltdown, for example.

For one thing, putting in place very aggressive triggers that essentially turn off trading in certain names, even briefly, or shut down certain market makers' systems can make things worse in instances when a quick reaction could've solved the problem. Leaving the rest of the market in the dark while it gets addressed (or leaving the market maker out there like a sitting duck) is never ideal.

More importantly, it's worth remembering that trading strategies at hedge funds and elsewhere may well be betting substantial sums, in good faith, that a price will naturally plunge below a certain threshold, by playing in options for example. With the proliferation of binary options lately, more individual investors might be doing the same, too.

Automatically locked-in pauses at certain percentage loss floors are probably part of their calculus these days (or ought to be), but should they need to be? Does a trading day look different when it's missing five or ten minutes? Of course it does.

Again, what does a "free market" really look like in 2015?

Further Research

As Zhao noted, more research is warranted regarding the breakers' effectiveness yesterday — and that's especially true given the widespread number of listings that were tripped up. One gets the feeling that at least a few more days of this volatility are in store, so more than enough data will be available.

But a major market correction in China seemed to be suggested for weeks, and I'd almost be more curious about the short bets that have been lost because of pauses kicking in at various points, or indeed the ways that this could potentially happen more frequently if stronger controls were introduced later on.

Perhaps it's easy to say that on a day when the US markets were only knocked a few percentage points down, despite the greater tumult going on to the east. Perhaps breakers would also begin looking more useful (and possibly effective) next time we get to day three or four of a global sell-off.

But just the same, circuit breakers go to the bigger question of what we really want out of our exchanges — efficiency or stability?

What's the reasonable balance to strike when markets halfway around the world acting rationally — rather than a software glitch — are the cause?