With the recent market volatility, a reminder on how circuit breakers work may be timely. Essentially circuit breakers temporarily pause trading once certain decline thresholds are met and can ultimately close the market early should the decline be sufficiently large.
The Detail of S&P 500 Circuit Breakers
For the New York Stock Exchange (NYSE) circuit breakers have three tiers. These circuit breakers react to the price change in the S&P 500. The first tier is a 7% decline in the S&P 500. Should that occur, trading will pause for 15 minutes. The next level is a 13% decline, that causes another 15 minute pause if it happens on or before 3.25pm. Finally should the markets fall 20% the markets will close for the day. All these price changes are relative to the previous trading day’s close.
At the time of writing, these circuit-breakers have not been triggered in their current form. However, the events of 2020 could perhaps change that because volatility is approaching the elevated levels not seen since 2008-9 and daily price swings have been very large. However, even then usage of the first tier of the circuit breaker is by far the most likely. 7% one-day declines do happen, though they are rare. The only historical event for the S&P 500 that would have theoretically breached the other circuit breakers is Black Monday of October 1987.
Pros And Cons Of Circuit Breakers
The circuit-breakers seem most useful in liquidity events. If there are issues with order flow, then circuit-breakers can enable market makers to regroup over a 15 minute interval and perhaps bring the markets closer to balance. This may have been the issue on Black Monday when programmatic selling due to portfolio insurance, may have overwhelmed the market causing a massive price decline.
However, if a circuit breaker is triggered not by liquidity issues, but by newsflow then the value is less clear. For example, if the combination of the coronavirus and the oil price cause the markets to materially and rapidly reevaluate prospects for global economic growth, then a 15 minute pause in trading may be less useful. That is to say a 15 minute pause may not change anything if a view is fundamentally held. Of course, should a decline be due to one-off technical factors, the a pause may be extremely valuable.
Furthermore, there are some implications from overlapping global markets. If one market such as the NYSE triggers a circuit breaker, but other markets remain open, then it is highly likely that investors will still find a route to obtain their desired exposure in a different market not subject to a circuit breaker at the time.
Again, this gets to the point that circuit breakers help manage times of issues with liquidity, if there truly is an event that radically changes perceptions of valuation or growth, then circuit breakers are likely less valuable. Nonetheless, based on market history it appears usage of circuit breakers will be rate.