Circuit breakers are used by exchanges around the world to temporarily halt trading and reset markets during periods of heightened volatility. They were first introduced by the New York Stock Exchange after the 1987 Black Monday crisis.
Several circuit breakers were triggered across different jurisdictions in March 2020 due to COVID‑induced volatility. This reignited discussion among exchanges, regulators and market participants about the effectiveness of these mechanisms.
To examine these developments, the ASX’s General Manager of Market Operations, Ben Jackson, recently participated in a webinar hosted by the World Federation of Exchanges (WFE). Jackson shared ASX's insights about the impact of circuit breakers on market quality, as well as other mechanisms used by exchanges to manage volatility.
Circuit breakers are a useful tool
The WFE recently released a research paper that focuses on the effectiveness of the four market-wide circuit breakers (MWCBs) triggered in the United States during March 2020.
Overall, its findings suggest that these mechanisms have a positive impact on market quality during periods of extreme volatility. The paper found that MWCBs are associated with increased stock returns, lower trading costs, reduced selling pressure and more informative prices.
It also found that traders tend to hold back from making aggressive moves right before MWCBs are triggered. This ‘holding back’ hypothesis challenges the ‘magnet effect’ theory that circuit breakers cause more aggressive trading behaviour, which leads to more extreme price movements.
Jackson said the paper’s findings clearly demonstrate what a well-designed circuit breaker can achieve. “On those occasions in March 2020, pausing the US market seemed to have two effects: it seemed to relieve the pressure in the financial market, but then it also seemed to improve the market conditions after the trading halt,” he said.
However, Jackson noted that while circuit breakers are a useful tool for managing market volatility, they don’t always work. For example, he pointed to the failed introduction of these mechanisms in the Chinese market in January 2016.
“That’s a classic example where circuit breakers are designed to calm the market, but in fact caused a surge of frantic selling,” he said. “It’s important to get those trigger levels absolutely right … they were perhaps too low and too close to be effective.”
There’s no one-size-fits-all approach
Markets operate in different ways, which means their volatility control mechanisms need to be tailored to their specific characteristics.
The ASX doesn’t use circuit breakers like those employed on some international exchanges. Instead, the Australian Securities and Investments Commission applies a common set of Market Integrity Rules (MIRs) for all securities and futures markets in Australia.
These rules include the requirement of Anomalous Order Thresholds (AOTs) to calculate reference prices and limits for all ASX securities, managed funds products, CHESS depositary interests, Australian Government Securities and interest rate securities. The AOT reference price is updated every minute, from a VWAP of the previous two minutes and prevents the placing of aggressive orders that are above or below 10 per cent of the reference price.
The ASX also pauses trading in individual stocks for two minutes if the price triggers the Extreme Trade Range (ETR) mechanism, which is unique for every stock.
“We find that these mechanisms – a combination of AOTs and ETRs, strikes a good balance and results in an orderly market,” said Jackson. “On the one hand, it restricts sudden and large price movements, but on the other hand – and something that I think is important – is that it allows natural market forces to guide trading.”
Instilling confidence in the market
Volatility isn’t necessarily a bad thing for markets. It could reflect a healthy price formation process driven by events that are volatile themselves, according to Jackson. What is crucial is that market participants are confident in the ability of market operators to handle periods of heightened volatility.
The ASX’s volatility control mechanisms faced a big test on Friday 13 March 2020 when its equity market recorded 5.18 million transactions – more than double the record pre-COVID-19 volume of trades.
“It was certainly a fast market, but the markets weren’t out of control,” Jackson said. “And I think, more importantly, they were allowed to move to that breaking news about former US President Donald Trump declaring a national emergency for COVID-19, as well as Moderna’s favourable initial trial results for a vaccine, and we allowed those natural market forces. So, the mechanisms allowed price discovery and trading.”
“We had the confidence and the trust of our participants and of our market users that no matter how volatile we got, we would make the right decisions and that our mechanisms would stand true. I think we demonstrated that they did.”
The views, thoughts and opinions contained in this Focus article belong solely to the author and do not necessarily reflect the WFE’s policy position on the issue, or the WFE’s views or opinions.