Q&A: Market-Wide ‘Circuit Breaker’ Rules Proposed to Prevent Crashes
After the dramatic “flash crash” of May 6, in which the Dow Jones industrial average fell nearly 1,000 points in the space of a few minutes, regulators have been scrambling to pinpoint the crash’s cause and find a fix.
Late Tuesday, the Securities and Exchange Commission, along with major U.S. exchanges, proposed new rules that would halt trading for five minutes across all U.S. exchanges for individual S&P 500 stocks when those stocks move more than 10 percent in five minutes or less. The program would be on a pilot basis through Dec. 10 and would apply to the 50 or so U.S. exchanges, which have typically set their own rules and regulations for halting trading.
“We continue to believe that the market disruption of May 6 was exacerbated by disparate trading rules and conventions across the exchanges,” SEC Chairman Mary Schapiro said in a statement Tuesday. “As such, I believe it is important that all the exchanges quickly reached consensus on a set of uniform circuit breakers that would be triggered when needed.”
In a joint report investigating the causes of the rapid slide on May 6, the SEC and co-author Commodity Futures Trading Commission said that they had still not pinpointed an exact cause, but had several working hypotheses — including a sudden drop in liquidity — that they continue to investigate.
To make sense of the new rules and whether they may be effective, we spoke with James Angel, an associate professor at Georgetown University who specializes in the structure and regulation of financial markets.
Regulators have proposed market-wide ‘circuit-breaker’ rules. Can you explain what that means in this context and how the rules might work?
JAMES ANGEL: It’s really quite simple. Computers will monitor stock prices, and when they jump too far, too fast, the computer will call a time out, instead of having humans do it. The proposal is that when an individual stock jumps or falls 10 percent in 5 minutes or less, the computer will call a time out and then a few minutes the later it will restart the trading.
And how would that prevent something like the ‘flash crash’ of May 6?
JAMES ANGEL: What happened on May 6 was similar to the thunderstorms in Ohio that caused the East Coast blackout a couple of years ago. Normally our systems are robust enough to withstand those outages. But here, things started to misfire and I’m not talking about fat fingers [or erroneous orders], but the computers themselves. All the supporting systems had trouble keeping up with volume and what this did is it scared a lot of investors into the sidelines. And these are the people who normally step in and stabilize the market when prices dip.
The important thing is that this would provide a market-wide pause to the trades. It will give everyone a few minutes to notice that 1) something abnormal is happening, 2) check to makes sure the systems are operating properly, and 3) restart trading in a proper manner.
What complications might arise?
JAMES ANGEL: It’s fairly easy to halt trading across the markets. The exchanges can already call regulatory halts; they have just never done it automatically. They have had a slow-moving human. It happens almost every day – if you go to the Nasdaq trading website, they talk about the latest trading halts, when they happen.
We have built a very powerful, interconnected market system that is most of the time very fault tolerant. Under normal conditions, when one exchange has a hiccup, the other exchanges say, we will trade around them. Most of the time, it works so smoothly, the media never notices; it’s invisible to the consumer. But just like that thunderstorm in Ohio, when you have jittery markets plus huge volume, even though the exchange computer says, ‘I’m fine,’ the other computers that communicate out to traders elsewhere started to have hiccups. This happens when you have extraordinarily huge volume. When huge volume is straining everyone’s system, you can’t get good data, so you don’t put in any orders.
We need these shock absorbers. So, these [rules] are a good start. There are always unintended consequences. Now that we can call these [halts] more frequently, the question is how will it work in the back office. If people know what can lead to a halt, could gamers trigger trading halts? That’s why it’s a good that it’s a pilot program, so they can see what works.
What successes are regulators looking for in order to make these changes permanent?
JAMES ANGEL: They are only starting in the S&P 500 — and those stocks don’t generally jump 10 percent [quickly]. I expect it will be every week or so you may see one of these. And I will get cynical here and say that the regulators will declare victory and go on to other things. And unless it blows up, they’ll say it’s fixed. The SEC has gutted its capacity for economic analysis. I read the 150-page report and they are barking up the wrong tree, looking for the fat finger. It demonstrates how far behind they are.
[But the rules are] a good step forward. It’s actually impressive how quickly the new SEC is moving. I have a lot of criticism of the agency, but I think [Mary Schapiro](http://www.whorunsgov.com/Profiles/MaryLSchapiro) has done as good as job as one can since the agency she inherited was such a mess.