Outdated Circuit Breaker Rules Fanned Flame of Decline

Steve Kanaval |

2015 was a year of market volatility. Between August 19th and August 25th the market dropped a staggering 12% and tested circuit breakers installed after the 1987 Stock Market crash. This week in August proved that the system is outdated and vulnerable. The market we know today is a completely different animal with daily volume dominated by High Frequency Trading (HFT), a handful of institutions and a lack of retail participation. I noticed the difference just listening to friends talk about their 401-K's and how their equity assets moved during this volatile week. I also hear much squawking from professional traders who see big changes coming.

During the August pullback shares declined this 12% across most major indexes, and it happened hard and fast. Markets blew through all stop signs, stop loss orders, and circuit breakers like they didn’t exist. According to most portfolio managers I spoke with (who traded other volatile markets in 1987, 2000, and 2010) said something the likes of, “This was as untradeable a market as we have ever seen" and “there was absolutely no way to trade no matter what platform you were using”.

The circuit breakers installed in 1987 did not work, and many stocks did not trade a share, which is the enemy of any portfolio manager. Thoughts about how to govern a decline remains outdated and is in need of repair. The only saving grace is that retail didn't participate (or blink) because it happened so fast. But smart market participants know that our publicly traded markets cannot survive in the long run without retail investors and a change to the current environment.

A report released by the SEC said this:

The Securities and Exchange Commission’s analysis of the events on Aug. 24 said price bands imposed by exchange NYSE Arca restricted how quickly ETFs could rebound after steep price declines triggered halts. Arca’s narrow bands, which it has since proposed to widen, may have spurred more delays by limiting faster price adjustments, the regulator’s report said.

The 88-page study, which was issued by the SEC’s staff and didn’t propose any policy fixes, gives the agency’s commissioners and industry groups a blueprint for debating structural changes to stock and ETF trading. The analysis cited multiple factors that contributed to the volatility, including the use of orders that execute at the prevailing market price, no matter how far prices rise or fall. These so-called market orders contributed to an excess of selling, which helped further push down prices, the SEC said.

Regulators and stock exchange officials continue to discuss changes that could minimize the likelihood of another event like the August turmoil that caused more than 1,000 trading halts in 327 exchange-traded products. The focus is on how to tweak safeguards put in place after the May 2010 flash crash, when prices for more than 300 securities varied by more than 60 percent. The protections, known as “limit-up, limit-down,” cause trading to be halted when prices increase or decrease by a certain threshold."

Trading halts did not allow markets to open and other tools designed to assist simply did not work. It’s best to make an attempt to save the markets here and draw retail back into the mix. This is a difficult task when exchanges cater to HFT and Hedge Funds and regulators continue to be clueless.

More likely what will happen is the days of large exchanges will fall away and more useful liquidity will emerge. This will come from the change blockchain will bring and the lock on ways to trade assets will become wider. This is already occurring in private market trading. AirBnb is already more liquid than Facebook (FB) and this will not be changing soon. Markets will be easier to access and have better technology than the current antiquated way exchanges trade today; they all still seem to be living in the world of 1987.

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