When the Trading Floor Goes Silent
U.S. stocks automatically halted trading this afternoon for the fourth time in the last eight days. (Trading also had stopped on March 9 and March 12.) The pauses happened shortly after the markets opened and lasted 15 minutes. The March 9 halt was the first time since 1997 that all trading was temporarily stopped after it had begun for the day.
What is the origin of these automatic pauses, most commonly referred to as circuit breakers, what are they supposed to do, and are there other rules that are meant to prevent market free fall?
The circuit breakers find their origin in the aftermath of Black Monday—October 19, 1987. Trading never was halted that day, and the Dow Jones Industrial Average (DJIA) plunged almost 22 percent.
The idea came from the Task Force on Market Mechanisms (more commonly known as the Brady Commission), which was assembled by President Ronald Reagan in 1988 to investigate the causes behind the prior year’s stock market crash and to make recommendations to prevent it from happening again. As The Wall Street Journal explains, the breakers were meant “to give traders additional time to think and digest information during swift market moves, helping to stabilize markets during episodes of extreme volatility.”
The New York Stock Exchange (NYSE) adopted many of the commission’s recommendations and, according to a 1988 Los Angeles Times article, along with the Chicago Mercantile Exchange that year “proposed a collection of market reforms that include[d] imposing coordinated trading halts.” According to veteran CNBC reporter Bob Pisani, as originally conceived, the rules “required the markets to pause for 30 minutes if the Dow dropped 350 points.” Then, “another circuit breaker would halt trading for an hour if it dropped 200 more points.” If that decline happened in the last hour of trading, the market could simply shut down for the rest of the day.
The U.S. Securities and Exchange Commission (SEC) approved the measures for the NYSE and they went into effect in 1988. At the time the Los Angeles Times said the reforms were supposed to be a “one-year experiment.”
As we now know, they were not.
The first time the circuit breakers were tripped was in 1997 during the Asian Financial Crisis when the DJIA fell 550 points and the market closed for the day.
The rules were changed after that crisis. In 1998, the SEC approved alterations to the circuit breaker policy. As the Los Angeles Times explained at the time, starting in April 1998, market triggers trading would halt for an hour when the DJIA fell 10 percent, for two hours when it fell 20 percent, and for the rest of the day when it fell 30 percent. Additionally, “each calendar quarter, the new trigger levels will be converted into point values, using the average closing value of the Dow average during the previous month.”
That calculation stayed in place for about 14 years. But before we discuss what happened next, let’s look at some other rules that are in place to prevent volatility in the markets.
In 2007, the SEC made changes to another policy—the uptick rule. As the Congressional Research Service (CRS) explains, under the 1934 Securities Exchange Act, the uptick rule, which placed limitations on short-selling in a declining market. In June 2007, the SEC ended this rule.
That decision, however, was relatively short-lived. According to CRS, “In the months following the rule’s withdrawal, some concerns arose that there might be a relationship between that action and a perceived heightening of stock market volatility.” As we know, throughout 2008, matters only would get more volatile. As a result, “During part of September and October 2008, the SEC temporarily suspended all short selling in about 1,000 financial stocks.” (CRS explains that, during the market meltdown of 2008, other nations, including the United Kingdom, Australia, and Germany, also adopted temporary bans on shorting financial firms.)
Then-SEC Chairman Christopher Cox said the ban “would not be necessary in a well-functioning market” and indicated it would be “temporary in nature.” A year later, however, the SEC was considering whether it should reinstate the uptick rule.
It did, with changes.
In February 2010, the SEC approved a new short sale price test restriction, now commonly referred to as the “alternative uptick rule.” This regulation restricted “short selling from further driving down the price of a stock that has dropped more than 10 percent in one day” and “required “trading centers to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the execution or display of a prohibited short sale.”
Two years later, in June 2012, the SEC approved a “limit up-limit down” mechanism that altered the alternative uptick rule. These changes were supposed to prevent “trades in individual listed equity securities from occurring outside of a specified price band, which would be set at a percentage level above and below the average price of the security over the immediately preceding five-minute period.” For more liquid securities in the S&P 500 Index, Russell 1000 Index, and certain exchange-traded products, the level was five percent. For other listed securities it was 10 percent. Additionally, the SEC said that, “under the new plan all trading centers, including exchanges, automated trading venues, and broker-dealers executing trades internally, must establish policies and procedures to prevent trades from occurring outside the applicable price bands, honor any trading pause, and otherwise comply with the procedures set forth in the plan.”
In June 2012, the SEC also approved changes to the general circuit breaker rule, and that rule still is in effect today. Currently, breakers are tied to declines in the S&P 500. They kick in at three different levels. There is a 15-minute halt if the S&P falls seven percent or more before 3:25 p.m. Eastern Time. (After 3:25 p.m. there are no halts unless declines reach the “level 3” marker.”) Those “level 1” stoppages are what we have seen over the last 10 days. If the S&P continues to decline and is down 13 percent, trading halts again for another 15 minutes. That’s “level 2,” and “level 2” also applies only before 3:25 p.m. If “level 2” hits after 3:25 p.m. trading continues until the end of the trading day unless “level 3” is reached. If the S&P declines 20 percent in one day, trading would cease for the day. That’s “level three” and this halt can happen at any time during the trading day.
Circuit breaker mechanisms are now widely used around the world. According to a survey of international trading venues by the World Federation of Exchanges, the majority (86 percent) of the responding trading venues “use circuit breakers to ensure investor protection and to increase market integrity and stability.” That figure is up from 60 percent in 2008. Most mechanisms, the paper said, are like those in the United States—triggered by predetermined price ranges.
Now, over the last few days, more journalists, analysts, and policymakers have asked whether the market should just shut down altogether during this crisis. Is there precedent for that?
According to TheStreet and Mother Jones, there is. Snowstorms, blackouts, strikes—and even the celebration following the Apollo 11 moon landing—all led to hours or day-long shutdowns, and some shutdowns last even longer.
The NYSE closed for an entire week after President Abraham Lincoln was assassinated in 1865. (The NYSE also closed the day President John F. Kennedy was assassinated, but only for the rest of the trading day.) The exchange was halted for 10 days in 1873 after the collapse of the Jay Cooke & Company, a major financial institution, and trading also halted after the September 11, 2001 terrorist attacks. The market did not reopen until September 17, 2001.
In July 1914, when World War I broke out in Europe, the NYSE halted trading for an incredible four months. (And, recall, the United States would not even engage in the conflict for several more years.) That closure is the longest one on record.
And let’s hope that’s a record that stands.