Can circuit breakers stop panic selling?

Buffeted by the spiralling coronavirus fallout and the unexpected oil price rout, for the second time in the past few weeks, stock markets triggered a trading halt on exchanges both sides of the border. The NYSE and the TSX both suspended trading shortly after open this Monday (March 12) as the market continued their freefall, plunging 8% within seconds, at which point market-wide circuit breakers tripped, and trading was stopped for 15 minutes to cool things off.

The idea behind an automatic halt to trading is to calm panic-stricken markets by forcing investors to take a brief pause from the ongoing chaos, review and reassess the situation, and acquire and assimilate information.

The New York Stock Exchange president Stacey Cunningham said that the trading halt was “working as it’s designed to function so that the market can absorb what news was out overnight, how investors are reacting so they can make decisions, and everyone gets a chance to see what’s happening.”

In an era of high-frequency computerized trading, circuit breakers act as a speed bump when markets are in a tailspin and help restore calm. Here’s how they work.

How circuit breakers work
The 15-minute stock-market trading halts activate at three thresholds amid sharp and large downturn and volatility: Level 1 triggers a 15-minute trading pause when the market falls 7% below its previous close; Level 2 trading halt kicks in when the market slides 13%; and, finally, when the index craters 20%, Level 3 gets activated, suspending trading for the remainder of the day.

Level 1 and 2 halts are triggered only if market drop occurs before 3:25 p.m. Trading will continue if the fall occurs at or after 3:25 p.m. Level 3 halt can kick in any time during the trading day, which closes markets for the rest of the day. You can learn more about trading halts here.

The idea is to call a brief time out allowing the chance to better match up buy and sell orders so when markets reopen they can function more smoothly and avoid exaggerated pricing due to illiquidity, says Greg McBride, chief financial analyst at the U.S.-based financial services firm Bankrate.com. He calls it the “equivalent of catching your breath and counting to 10 before you say or do something rash.”

But is it an effective mechanism to control a wild, sentiment-drive churn?

Can circuit breakerscalm the waters?
Broadly, research suggests trading halts are efficient in maintaining stability and an orderly trading in the market. Pauses in trading serve to facilitate price discovery process by allowing investors the opportunity to digest the material information and adjust their trading interests.

But to calm panic? Not so much. Experts suggest such trading halts have a limited impact on an overall panic-selling activity, and in fact make people think they can’t sell, making them feel more anxious and ready to sell at any price.

“A trading halt is helpful to stem day to day declines, but it's a negative if (circuit breakers) keep getting triggered, as that will trigger a negative fear of missing out (FOMO) thematic,” says Toronto-based Darren Sissons, vice president and partner at Campbell, Lee & Ross.

Retail investors don’t fully understand how quantitative trading affects markets during times of panic, especially due to force majeure reasons such as the coronavirus outbreak.

“Not just retail investors, no one fully understands until we’re in the middle of it or with the benefit of hindsight,” says McBride. "Programs run by computers can cause a stampede of selling because it is automated based on complicated formulas. There’s no grown up in the room to say, ‘Hey, wait a minute, is this correct?'”

Program trading is actually enhancing risk at present as the underlying program narrative is to sell now, argues Sissons, adding that “the selloff is happening with a complete disregard for fundamentals. Companies with net cash (more cash than debt) shouldn't be getting pummeled.”

In the end, the fundamentals win. “Within the context of properly functioning of markets, the fundamentals can be assessed and the price discovery that occurs helps establish where the bottom is,” says McBride.

What can happen next?
This week’s market halts, however, didn’t appear to nearly achieve that objective. U.S. stocks pared some of their steep losses momentarily on Thursday after the Federal Reserve intervention injecting US$1.5 trillion to stem the carnage. However, the selling intensified right after trading resumption with the Dow closing off the day with a brutal 10% plunge, its worst since the 1987 market crash. In a similar fate, the day’s meltdown wiped out years’ worth of TSX gains, pushing the benchmark back to 2016 levels.

The out of whack situation, which Sissons refers to as full blown Black Swan is expected to get worse before it gets better. There are three key negative forces that may continue to drag markets lower. 

First, investors did not appreciate the Saudi’s price move was supportive or accommodative rather than manipulative.  Second, Italy became an uncontrollable European epicentre spawning new cases of the dreaded coronavirus all over Europe, causing more pain. Further, Trump's travel ban has all but guaranteed a recession, he adds.

Finally, with interest rates at record lows, central banks are out of ammunition. “Collective, policy errors from central banks on interest rates and a market overreaction have led to panic selling,” asserts Sissons. “Best case is investors find a little peace and calm down.”

Likelihood of that happening near term, though, is one in 20, Sissons adds.