Brownouts Over Blackouts: Market Circuit Breaker Alternatives

The Center for Innovative Financial Technology (CIFT), a part of the Livermore Berkeley National Laboratory, recently issued a whitepaper that offers alternatives to the market circuit breaker rules put forth by the US Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) after the May 6, 2010 Flash Crash.

The paper suggests implementing market indicators to identify imbalances in the trading environment and then slow down trading rather than cease it all together.

The two indicators mentioned are the Volume Synchronized Probability of Informed Trading (VPIN) and a version of the Herfindahl–Hirschman Index (HHI), both of which just consume trade and quote (TAQ) data.

The VPIN indicator, which is based on the earlier Probability of Informed Trading (PIN) model but replaces volume for PIN's time increment, measures the balance between buy and sell activities based on volume-time rather than PIN's clock-time measurement.

The Volume Herfindahl Index is one of the many flavors of HHI, which are widely used to measure the concentration of industrial production and other operations, according to the authors.

When the researchers fed both models historical data leading up to and including May 6, 2010, each showed a strong indication that a flash crash was approaching.

The paper's focus is more on how the researchers used a supercomputing environment and converted the historical data to version 5 of the Hierarchical Data Format (HDF5) from its original ASCII-based CSV format to reduce its overall footprint and make it easier to number-crunch. However, the endnotes are a treasure trove of sources.

Given how far the US markets have gone down the road with the industry-wide circuit breakers, it is doubtful that the regulators will look to scrap them in favor of another model. But if individual firms are looking to implement their own indicators to know when the circuit breaker might trip, this is definitely worth a read.