Today, a large majority of exchanges around the world have introduced circuit breakers as a safeguarding mechanism for volatile market conditions. While circuit breakers remain a critical tool in securities and futures markets, the dynamic nature of modern markets has also led to various schools of thought emerging around the use of such volatility control mechanisms.
Modern electronic markets are dynamic, responsive and highly non-linear feedback mechanisms which incorporate -- in real-time -- human and machine reactions to new information, in order to generate ‘price innovation’ from ‘information innovation.’ We will need some humility in presuming that there are simple, persistent and universal ‘volatility control measures’ we can design on a desktop. As Mike Tyson famously noted: everybody has a plan until they get punched in the mouth.
What do previous experiences tell us?
Circuit breakers have proven to be a useful tool for stock markets. For SGX Group, during the height of the pandemic in March 2020, our priority was to ensure that our markets were always available and accessible. Our dynamic circuit breakers worked as intended throughout the surge in trading activity and volume. Because the circuit breakers successfully moderated sharp price movements, we were able to keep our markets open the entire time.
And then, there was the instance with China’s securities regulator CSRC introducing a circuit breaker mechanism to stem market volatility in the New Year of 2016. The mechanism, however, was widely acknowledged to have actually exaggerated the fall in the market, triggering two trading halts. The mechanism was suspended by the CSRC after operating for four days. The trigger points were set at 5% and 7% from previous close. In hindsight (and for many, in foresight), market operators generally conclude that a naïve excess of regulatory virtue (many think that if a 10% limit is good for volatility control, a 5% limit must be better) led to panicked retail investors seeking to exit their positions before the market was frozen, thus triggering a self-fulfilling doom loop.
This then is the matter that deserves some thought; we do know from past experiences that circuit breakers have shown to work. But in other circumstances, a circuit breaker may actually increase risks and uncertainties in the market. Why so?
The ‘heartbeat’ of exchanges
Most electronic exchanges operate price-time priority for a continuous double-sided auction. Such an auction seldom springs into life by itself. The >99% failure rate of an auction for new product launches on exchanges testifies to this! Furthermore, even for products which have successful liquidity, the auction’s heartbeat ceases every day and has to restart successfully the next trading day.
For most modern exchanges, this restart process is through an initiating auction, where the new day’s session is kicked off with a (non-time priority, commonly Walrasian) auction to collect opening bids and offers, in order to launch the market’s first trade in a ‘pre-balanced' way.
Here then lies perhaps a dilemma with circuit breakers. The heartbeat of a living, breathing, real-time auction is interrupted in the belief that the auction is failing due to excessive movement in prices; that there is collective disequilibrium between buyers and sellers; and that participants need a timeout in order to calm their panic and re-establish their individual equilibria.
The challenge comes after the circuit breaker is relaxed, and individual participants have their blindfolds removed and are invited to jump back in to play again. Real-world news flow ticked on during the timeout period, and now participants have lost track of the field positions of other buyers and sellers. Should they jump right back in? Or do they wait for others to take to the field first?
Should we let nature take its course?
In my experience, in emerging market equity indices, disorder may result after the release of a circuit breaker because the underlying price may have moved much further on during the time matching was paused. This causes risk to participants who were not able to hedge in the meantime. It also causes risk to the auction which was not restarted in a clean and balanced way because of an overhang of unfulfilled orders caused by the circuit breaker.
Applying a circuit breaker to a live auction is tantamount to stopping your heartbeat and hoping to restart it to a normality in a few minutes. It would have been worthwhile a posteriori if you had managed to reset a fibrillating patient’s heart to a normal rhythm; but what if you do not?
The regulatory and statutory obligation of modern exchanges is to operate fair, orderly and transparent pricing auctions. To paraphrase Justice Potter Stewart: “I can’t tell you what orderly is, but I know it when I see it”. For SGX Group, our position is that stocks move up and down and as long as they do not do so in a disorderly manner, we should not stop that in the belief that sometimes, excessive intervention by the auction operator may decrease competence, discipline and risk awareness in market participants.
When intervention may increase risk
As we explored during the WFE webinar, there are certainly circumstances where SGX Group and ASX believe price limits create significant risk of disorderliness. The obvious one is where the underlying price is a wholesale or sovereign asset such as government bond yields, or foreign exchange rates. The action of governments and central banks in these markets is often to nudge (or deliberately shock) markets through forceful intervention. Interrupting the price formation process with a circuit breaker during a ‘repricing’ period is likely to increase systemic risk.
Other markets where price limits can potentially increase systemic risk are wholesale commodity markets (including digital commodities) where supply and demand are global in scale, and interruptions (e.g. cessation of a major mine or transport route) are real-world events which market prices must react to, in order for the real economy to adapt as quickly as possible. As the farmer’s saying goes: the best cure for high prices is a period of high prices, and likewise for low prices.
In recent months, with massive disruption and reconfiguration of energy supply chains globally, we have seen huge but ‘orderly’ price movements in the prices of power and gas. Over the COVID-19 period we saw surges in freight prices and many commodity prices due to constraints caused by restriction measures. These are real world reconfigurations in supply and demand which need to be broadcast and digested by global markets in order to trigger adaptation and deploy risk-management plans. The action of the Invisible Hand works over time to marshal the selfish actions of greedy individuals into a precious modern public good: an orderly tradeable price to buy and sell.
Modern finance is built on this revolutionary insight. Unlike in preceding centuries of actuarial risk management in finance, where risk prices are set by insurance underwriters looking at historical tables, we can in fact price financial products in a ‘risk neutral’ world. In this world, as long as the price is continuously tradeable, I can hedge the risk away whether the price is in fact accurate in the sense of predicting some future outcome.
Options pricing with barriers and strikes, continuous and binary payouts – these systems are built on the bedrock of continuous time finance, where there is a continuously available marketplace for price risk, on which to hedge and replicate customised payout profiles for both speculators and risk managers.
Calibrate to suit varied market structures
So how might we close the gap between these two imperatives: the obligation of market operators to intervene in failing auctions in the name of fairness, orderliness and transparency … and the desire to maximise the economic and medicinal benefits of market discipline?
Many exchanges implement electronic pre-trade controls to limit the systemic impact of large price movements (and hence increase the resilience and capacity to undergo market discipline). These range from dynamic position accountability of leveraged creditors and customers, pre-trade risk controls, order throttles, active surveillance and supervision to adjust/bust prices without threatening trade/position certainty, and of course intelligent supervision of bank and broker intermediaries who are the primary conduits of contagion risk into exchanges.
But it may be worth noting that circuit breakers are not an all-encompassing mechanism that will always work in the way intended. The assumption that trading will restart instantaneously after circuit breakers are triggered may not always hold true.
Over the years, exchanges and regulators have learnt from past experiences and as with different jurisdictions and markets, it is evident that each comes with varying needs so there is not a one-size fits-all solution for all situations.
In future, matching engines with better software or hardware control of market order throttles, a desirable design evolution may very well be to slow down auction clock time. This is not an engineering challenge to be underestimated when considered across a complex network of data centres and communication networks built around maximal asynchronous information transfer. But it may contribute to the future of better exchange markets, and properly advance the current discussions around Volatility Control Measures.
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.