Circuit breakers as market stability levers: A survey of research, praxis, and challenges

Abstract

Circuit breaker, an automated regulatory instrument employed to deter panic, temper volatility, and prevent crashes, is controversial in financial markets. Proponents claim it provides a propitious time out when price levels are stressed and persuades traders to make rational trading decisions. Opponents demur its potency, dubbing it a barrier to laissez‐faire price discovery process. Since conceptualization in 1970s and practice from 1980s, researchers focused mostly on its ability to allay panic, interference in trading, volatility transmission, prospect of self‐fulfilling prophecy through gravitational pull towards itself, and delayed dissemination of information. Though financial economists are forked on circuit breakers' usefulness, they are a clear favourite among regulators, who downplay the reliability of anti‐circuit breaker findings citing, inter alia, suspect methodology, and lack of statistical power. In the backdrop of 2007–2008 Crisis and 2010 Flash Crash, the drumbeats for more regulatory intervention in markets grew louder. Hence, it is unlikely that intervening mechanism such as circuit breakers will ebb. But are circuit breakers worth it? This paper synthesizes three decades of theoretical and empirical works, underlines the limitations, issues, and methodological shortcomings undermining findings, attempts to explain regulatory rationale, and provides direction for future research in an increasingly complex market climate.

Ex-post effects of circuit breakers in crisis and calm markets

“…We test three ex-post hypotheses identified by Sifat and Mohamad (2018) as the main objections to price limits' efficacy: volatility spillover, price discovery delay, and trading interference (Table III). This paper adopts the methodology pioneered by Kim and Rhee (1997) to test volatility spillover, delayed price discovery, and trading interference.…”

“…The price discovery delay hypothesis is based on multiple return series constructed for all limit-hit securities, which are then used to determine whether prices experience more continuations or reversal on triggered days, as this would be indicative of price limits impeding the process of discovery of fair prices (Miao et al , 2017). Lastly, for the trading interference hypothesis, the theoreticians hold that if circuit breakers indeed suppressed liquidity, trading volume would diminish drastically on the triggered days and increase substantially thereafter (Sifat and Mohamad, 2018). As trading activities wax on the subsequent trading days, rational trading is cut short on the day limit is hit.…”

“…As for the ex-post hypotheses, daily data sets are adequate and traditionally used to compare volatility, price reversal, and trading activity performances on and after the trigger-hit day. In this approach, the trigger-hit group is pitted against a control group (pseudo-hit or quasi-hit) to determine whether volatility worsens, price discovery is delayed, and traders' activities are hindered (Sifat and Mohamad, 2018).…”

“…Lastly, examining a wide band limit contributes to the ongoing debate on the optimum range of a price limit. Though it may be intuitive that wide price limits may be innocuous, prior widening experimentation by Thailand and Korea in the late 1990s yielded ambiguous results (Sifat and Mohamad, 2018). Consequently, understanding the repercussions of a wide band limit remains a significant policy issue and warrants a deeper scrutiny due to its regulatory and policy-related import.…”

“…A distinguishing feature of ex-post vs ex-ante effect studies is that due to the inherently intraday nature of the magnet effect, end-of-day closing price data sets are ineffective in capturing the existence of a gravitational pull of the trigger point in hastening order flow (Sifat and Mohamad, 2018). Yet, many early researchers, presumably due to dearth of granular data, improvised with daily data sets by using overnight returns or jumps as a predictor of magnet effect the following day.…”