The Circuit Breaker System In The Stock Market
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The effects of the Crash of 1987 were not as devastating as expected. No depression, big or small resulted from it, and, in retrospect, was actually seen as a marvelous buying opportunity.
In the following decade, interest rates declined, and investors displayed a renwed trust in the market. Investors returned to the market as it made a comeback and began to rise. But this renewed trust was also bolstered by some precautionary procedures that were implemented after the crash.
Circuit Breakers and Limits
Circuit breakers were put into place in 1988 in order to keep any future market drops from transforming into panics.
They were controversial at the time of their installation and have remained so. Many critics of the circuit breakers believe that instead of making share prices less volatile, they increased them instead. There are three stages in the establishment of the circuit breaker device. The first two stages are sometimes referred to as collars. The first step is described as the least obstructive.
The plan in this step limits computer program trading from sending orders to the New York Stock Exchange if the Dow has risen or fallen more than 50-points from the earlier day’s close. Upon the placement of the circuit breakers, a 50-point change was tantamount to a 2% modification in the Dow. But as the DJIA rises, a 50-point change becomes minimal. Because of this fact, the first step is used more frequently.
In the second stage of the circuit breaker plan, program trading is postponed for 5 minutes if the Dow loses 96 points and the Standard & Poor’s 500 stock-index drops by more than 12 points.
This stage restricts traders using computer programs to make large orders. These investors abuse the price differences between particular exchanges. Some blame their pejorative manipulation of the market to be the cause of the crash.
The third circuit breaker phase was designed to stop trading in all U.S. major exchanges for an hour if the Dow fell 250 points in a day. The tradings would then continue after the hour had expired, but if the Dow continued to fall 150 points after tradings continued, the market would then close for two more hours.
These regulations have been modified so that a 350-point fall would spur a thirty minute stop in trading and another 200-point fall would evoke a one hour suspension of the market.
The circuit breakers were installed primarily to prevent extreme changes in the stock market. Their usefulness is often in doubt because in order to prevent extreme shifts in the market the causes of values change must be revealed.
There are several suggestions as to what can cause these changes.
A primary cause is the fundamental changes in the economy, including the availability of money or the changes in interest rates. Here restrictions on trading are detrimental because they can decrease the effectiveness of the pricing in the stock market. The advocates of circuit breakers insist that periods of suspension of the market will allow time for the investors to consider what their next move will be and how to overcome this large price move.
Yet, that investors will sit and contemplate the reasoning behind the drop in points is unlikely. Most are proned to become nervous and anxious as they consider what the market will do when it resumes.
Lawrence Harris, an economist at the University of Southern California, has sought to determine if circuit breaker restrictions have made a difference in the market.
His results have found that the average daily volatility of share prices has decreased since the introduction of circuit breakers. But Harris believes that this does not verify the beneficial aspects of circuit breakers. Harris attributes the lower daily votality of share prices to the skepticism of investors and the high inflation rate in the U.S.
When the differences of inflation are revised, Harris found that the votality before and after the placement of the circuit breakers are very closely related. In fact, votality has increased and is now greater than before their installation.
The stock market has not experienced any extreme changes in prices which may suggest that circuit breakers have made a difference, but that fact could also mean that the circuit breakers have yet to be fully tested. Harris acknowledges that these restrictions have had a small effect in the Dow, but he concludes that circuit breakers have not had an obvious effect that can be easily distinguished.
"The Economist" writers believe whether circuit breakers made a difference or not is not the point. The magazine's analysts understand that after the crash of 1987, federal regulators were pressured to prevent any sort of crash again. But no one knows the best way to prevent a crash from occurring.
In order to design preventive measures that would protect the market from dangerous declines, the regulators imposed the circuit breakers that would act as weak restraints and would probably do no harm.
"The Economist" writers seem to believe that the circuit breakers have little to do with the stock market but demonstrate more about the use of regulation. Because of the very weak restraints provided by these circuit breakers, it does seem that their purpose is to cover the backs of the stock market regulators.
If they did nothing to try to prevent another crash, the public would not regard them very highly. If nothing was done after the crash, the public would distrust the market and it's high volatility. Because of this distrust, investors would be reluctant to put their money in the market and might instead invest it in the bank where interest rates would climb and the market would decline.
Ricky Schmidt
August 12, 2003
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