A circuit breaker, in financial markets, is a mechanism that temporarily halts or restricts trading when the price of a security or an index moves by more than a preset amount within a defined time. The name is borrowed from the electrical device that cuts off current to prevent damage. Exchanges and regulators use circuit breakers to slow disorderly price moves, give participants time to absorb information and reduce the chance that errors or panic feed on themselves.
Circuit breakers are automatic and rule-based. They differ from a discretionary trading suspension ordered by a regulator or exchange for a specific reason, such as pending news about a company, although both result in a trading halt. They may apply to a whole market or to a single instrument.
Market-wide circuit breakers
A market-wide circuit breaker stops trading in all shares, and related futures and options, when a broad stock market index falls sharply. The United States adopted the first such rules after the crash of 19 October 1987, on the recommendation of a presidential task force.
Under the current United States rules, the trigger is the decline in the S&P 500 index from the previous day's close. A fall of 7% (Level 1) or 13% (Level 2) halts trading across all markets for 15 minutes, unless it occurs late in the session. A fall of 20% (Level 3) ends trading for the rest of the day. A market-wide halt was first triggered in October 1997, under earlier thresholds. The present percentages date from 2013, and they were triggered four times in March 2020, during the market turmoil at the start of the COVID-19 pandemic.
Other countries use similar tools with different thresholds, and some have none. China introduced an index-based circuit breaker at the start of 2016 and withdrew it within days, after it was triggered twice in its first week and appeared to accelerate selling.
Single-security mechanisms
Most halts in practice affect individual instruments. Three designs are common:
- Price bands. In the United States, the limit up-limit down mechanism prevents trades in a share outside a band set as a percentage above and below its average price over the preceding five minutes. If the price stays at the limit for 15 seconds, trading pauses for five minutes.
- Volatility auctions. European exchanges interrupt continuous trading and switch to a call auction when the next trade would fall outside a static or dynamic price range; see volatility interruption. Trading resumes when the auction establishes a new price.
- Daily price limits. Many Asian stock markets, and commodity futures exchanges worldwide, set a maximum move from the previous close. Trading can continue at or within the limit but not beyond it.
In the European Union, MiFID II requires trading venues to be able to halt or constrain trading temporarily when there is a significant price movement, and to calibrate the parameters to each instrument.
Purpose and rationale
Electronic markets can move faster than people can react. A large mistaken order, a faulty algorithm or a sudden withdrawal of liquidity can drive prices far from any reasonable value within seconds, as in the flash crash of 6 May 2010, when United States share indices fell and largely recovered within about half an hour. That event led directly to the single-stock mechanisms now in place.
A pause serves several functions. It gives investors time to assess whether new information justifies the move. It allows firms engaged in algorithmic trading to check their systems and lets a market maker reassess quotes. It gives exchanges and clearing houses time to collect margin. And it allows trading to restart through an auction similar to the opening auction, which gathers orders at one moment and supports price discovery.
Criticism
Evidence on whether circuit breakers calm markets is mixed. The main objection is the magnet effect: as prices approach a threshold, traders may rush to sell before the halt, pulling the price towards the limit faster than it would otherwise have moved. A halt also delays trading without removing the reason for it, so volatility can simply reappear afterwards or spill into related markets that remain open.
Halts interfere with hedging and can leave investors unable to exit positions, which matters for holders of derivatives and exchange-traded funds whose components stop trading. Coordination is a further difficulty, since a share may trade on many venues and in several countries; in March 2020, halts in one market at times shifted pressure to others. Thresholds are hard to set, as limits that are too tight interrupt normal trading and limits that are too wide never bind.
Circuit breakers are one of several safeguards for orderly markets. Others include order price collars that reject orders far from the market, kill switches that cut off a malfunctioning participant, rules for cancelling clearly erroneous trades, temporary restrictions on short selling after a steep fall, and continuous market surveillance by exchanges. In the United States, the rules are approved and overseen by the Securities and Exchange Commission (SEC). Day-to-day, each stock exchange publishes its own parameters and announces halts and resumption times to the market.