WASHINGTON — On May 6, 2010, a large mutual fund trader initiated an order to sell more than $4 billion of E-Mini S&P futures contracts in 20 minutes. The sudden imbalance created a rush to sell, leading investors to trade about two billion shares between 2:40 p.m. and 3 p.m. This event, known as the Flash Crash, wiped out 9.2 percent of the Dow Jones Industrial Average’s value, with most of the slide taking place in five minutes.
“It was the kind of thing where if you went to the bathroom, you missed it,” said James Angel, associate professor at Georgetown University in Washington.
While the Dow recovered to end the day down only 3.2 percent, many demanded a tightening of the measures used to halt trading during a panic. They’re called circuit breakers.
In theory, market-wide circuit breakers are designed to alleviate the type of event that rattled Wall Street in 2010.
These precautions, much like those that were triggered twice two weeks ago in the Chinese market, exist to pause trading at the point that a stock market index starts to dramatically dip.
However, no market-wide breakers were tripped on the day of the Flash Crash, and these measures have in fact only been triggered once, in 1997. Furthermore, many experts question their ability to control volatility at all, and some warn that they could do harm in a market downturn.
While the SEC has been quiet on market-wide restrictions recently, the market drops that kicked off 2016, along with uncertainty in China’s market and low oil prices, suggest there will be opportunities for high volatility to play into this year’s trading.
U.S. markets have three levels of circuit breakers. If the S&P 500 goes down more than 7 percent from its previous closing value, trading halts for 15 minutes. The same thing happens at a 12 percent drop, and after 20 percent, trading halts for the day. The rationale behind these measures is that a pause prevents panic and gives traders time to assess the situation.
“Hopefully everyone can just take a break and it won’t keep going down,” said Norbert Michel, financial regulations research fellow at the Heritage Foundation. “It’s trying to head off a massive quick crash.”
However, many experts argue that circuit breakers can also interfere with the normal workings of the market. According to Professor Angel, market pauses can become self-fulfilling prophecies, driving trades down in anticipation of the market closing.
This phenomenon, known as a magnet effect, occurs when traders get nervous about getting locked out of trading. And while studies have not conclusively shown that such an effect exists in securities trading, Weifeng Zhong, research fellow at the American Enterprise Institute, said it’s what drove markets down in China last week.
In addition, a 1998 SEC report acknowledged that a magnet effect may have driven trading down toward breakers in October 1997, when the Dow dropped over 550 points and triggered market-wide halts for the first and only time. China’s government has since suspended its circuit breakers, just four days after they were implemented.
Experts also express concern that these measures prevent the market from signaling information. Jessica Wachter, professor of finance at The Wharton School, said limiting trading prevents news from informing market value, which diminishes the trustworthiness of the system. If the market can’t bottom out naturally, Wachter argues, then prices are suspended at higher values than they should be, misinforming investors while also preventing them from trading.
“Investors need to know that they can get their money out, if they want to,” she said in a phone interview.
However, Wachter added that circuit breakers can be helpful if a problem arises with the market itself, as they give exchanges a chance to alleviate fears related to the trading system.
Many times, volatility regulations begin or are changed as the result of a previous crash, rather than in anticipation of future events.
The SEC has adjusted market circuit breaker levels twice since they were implemented – once by switching from point-based restrictions to percentages in 1998 and once in 2012 to tighten percentages to current levels. Both of these changes occurred when regulators determined that levels were incorrectly set after major market downturns. This same pattern has also applied to other recent volatility rules, such as the reinstitution of short selling restrictions after the 2008 market downturn and the 2010 Flash Crash.
The gap between what the SEC can do and the speed at which the market moves has been criticized by experts for leading to ineffective regulations. But while many disagree with market-wide measures, some more focused rules help the market respond to specific instances of unusual volatility. Angel said breakers on individual stocks can be useful, as they allow trading halts to be targeted to problematic areas of the market.
“You need some kind of shock absorbers on each individual stock,” Angel said.
The SEC’s Limit Up-Limit Down Plan, instituted in 2012, fills this role by stopping a stock from moving outside of a certain range based on its average price from the previous five minutes of trading. And this sort of measure helped alleviate the 2010 Flash Crash, when the Chicago Mercantile Exchange Group paused trading on E-Mini S&P futures for five seconds and stopped cascading sell orders.
Georgetown’s Angel said regulation often seems to lag behind market events because of a lack of resources. The SEC is not staffed well enough to tackle everything that Congress asks it to oversee, and the agency can’t pay enough to retain top talent. Angel said that young regulators often cross over to industry work, attracted by the chance to make substantially more money.
“If you want good people in financial services, you’ve got to pay them,” he said. “The revolving door goes in the wrong direction.”
The rarity of extreme market events also presents a challenge to regulators, as it is difficult to prepare for something that happens so infrequently. This means that there is not much historical evidence to back up market-wide volatility regulation, because so little data is available in total.
“It is kind of a just in case thing,” Michel said.
As a result of this uncertainty, volatility regulation is subject to a lot of change and discussion. Thaya Knight, associate director of financial regulation studies at the Cato Institute, said that people are still experimenting with these regulations and trying to figure out how to adjust them in the future.
However, Angel said that the rarity of these events and the unique circumstances from one crash to another make them very difficult to regulate.
“We put something that we think is going to work in place,” he said. “And then we cross our fingers.”
