During times of extreme pricing volatility or market panic, the term "circuit breaker" is frequently used by traders, brokers and the financial media. Amid extraordinary events such as viral outbreaks or terrorist attacks, these devices are designed to prevent full-blown market crashes.
Circuit Breaker Defined
In the physical world, a circuit breaker is a safety mechanism used to cut the flow of electricity through a closed path. When engaged, electrical current is instantaneously disrupted and the delivery of voltage through the circuit terminates. It's at this point repairs can be safely completed, free from risk of electrocution. Circuit breakers accompany the vast majority of electrical installations, including those found in buildings, power grids and machinery.
As they pertain to the financial markets, circuit breakers are fail-safe mechanisms that immediately disrupt public trading. Upon being activated, traders and investors are not able to open new positions or close out existing positions; all activity is abruptly "curbed" in an attempt to restore efficient and orderly markets.
The ultimate objectives of a circuit breaker are multifold:
Preserve Market Efficiency
Market crashes are driven by the dominance of sellers over buyers. A halt in trade promotes buy-side liquidity as market participants are afforded time to evaluate asset prices at a stand-still, not as they fall.
Prevent Market Crashes
Before the coronavirus (COVID-19) panic of 2020, the two largest single-day losses for U.S. stocks occurred in 1929 and 1987. Known as Black Monday, the crash of 1929 sent the stock market lower by 12.8% on the fourth day of tumult. In October 1987, Black Monday II occurred and brought a staggering single-day loss of 23% for the aggregate American stock market. This event was the catalyst for the development and institution of circuit breakers in the marketplace.
Types Of Circuit Breakers
Although typically utilised in the financial markets of developed nations, circuit breaker procedures are not universal. Policies vary greatly according to locale, market and product. The primary differences between each type are in how trade is conducted once a defined volatility threshold is hit:
- Trading Halts: A trading halt is a complete stop to all buying and selling on the open market.
- Volatility Interruption: Upon market prices leaving a defined band or "tunnel," open trade is suspended for a short period. During this time, an unscheduled auction is conducted in an attempt to stabilise asset prices.
- Product-Specific Trading Halt: If an individual instrument violates a predetermined pricing extreme, trade is curbed for a designated period of time.
- Order Rejection Mechanism: In the event pricing volatility violates defined parameters, buy/sell orders sent to the exchange are not accepted.
An example of well-known circuit breakers include those put into place by the United States Securities and Exchange Commission (SEC) in 2012. The SEC's guidelines govern trade on U.S. markets, specifically the New York Stock Exchange (NYSE). As the world's largest equities exchange (an approximate market capitalisation of US$13.4 trillion), the NYSE halts the action at several predetermined levels.
Known as the Market Wide Circuit Breaker (MWCB), all trade ceases at the following thresholds:
* Level 1: The Level 1 MWCB is triggered when the Standard and Poor's 500 Index (S&P 500) falls by 7% from the prior day's closing price. Trade is halted for 15 minutes before resuming.
* Level 2: Upon the S&P 500 extending losses to 13%, the Level 2 MWCB is activated. Once again, trade is curbed for 15 minutes.
* Level 3: The Level 3 MWCB rests 20% below the previous day's settlement of the S&P 500. If hit, the session is suspended until the following business day.
For the NYSE's circuit breakers, Levels 1 and 2 may be triggered between 9:30 AM EST and 3:25 PM EST; a Level 3 breach can be executed at any time.
In addition to the MWCB, the SEC also outlines rules for the trade of individual stocks. The SEC establishes price bands for each corporate share at 5%, 10%, 20% or 75% of market price. Should volatility take price outside of these levels within a five-minute period, trade of said stock is halted for the subsequent five minutes.
In March 2020, trade on the world's markets was halted repeatedly as a result of the COVID-19 pandemic. For the NYSE, 9 March 2020 marked the first time since 1997 that trade was curbed ahead of a session's closing bell.
The early 2020 coronavirus outbreak brought unprecedented levels of volatility to the world's markets. Mass quarantines, central bank actions and emergency government stimulus programs forced the rapid repricing of most asset classes. Subsequently, circuit breakers played instrumental roles in preserving the efficiency of price discovery.