In the heat of last Monday's stock-market dive, the New York Stock Exchange debuted circuit breakers. Reviews of the procedure, which halts trading when the Dow Jones industrial average drops dramatically, are mixed. Most traders say that the pauses exacerbated the panic. Treasury Secretary Robert Rubin and others credit the pauses with calming jittery investors. What are circuit breakers? Why were they created? What is the evidence that they work?
Following the October 1987 Black Monday stock-market crash, a presidential task force was convened to investigate the crash's causes and suggest remedies that would prevent a repeat performance. The task force blamed "faulty market mechanisms." The exchanges, it argued, lacked the infrastructure to accommodate the trading volume that the drop occasioned: Phone lines clogged, computers crashed, and printers jammed. Many orders simply weren't received. Deluged traders couldn't match the buy and sell orders they had. The task force recommended--and in 1989 the New York Stock Exchange implemented--circuit breakers, a pause in trading that would give buyers and sellers time to assimilate incoming information and arrange transactions. Circuit breakers afford investors and traders the time to sell stock calmly, rather than dump it in a panic.
The main circuit breaker is an NYSE rule that automatically stops trading for 30 minutes whenever the Dow Jones industrial average tumbles 350 points from its previous day's close. Another circuit breaker halts trading for an hour if the market drops another 200 points. The NASDAQ exchange, the American Stock Exchange, and the Chicago Mercantile Exchange now stop trading whenever the NYSE stops. Also after 1987, the exchanges agreed to curtail computer trading of futures when the Dow Jones industrial average either gains or loses 50 points. This procedure is invoked regularly.
Although circuit breakers were first imposed this week, the governing board of the NYSE does stop trading when circumstances warrant it. Following the 1987 market crash, for instance, the NYSE shortened its hours to curtail panic trading. During the "paperwork crisis" of 1968, the NYSE cut back hours for the first three months of the year so that brokers could handle a massive backlog of unfilled orders. In addition, specialists--the traders who handle the transactions of an individual stock--are granted permission regularly by the NYSE to stop trading stock to restore temporary imbalances between supply and demand. Bad weather, presidential assassinations, and power outages all have resulted in the closing of the market.
Most foreign governments require localexchanges to halt the trading of stocks that have dropped drastically. Monday, markets in Tokyo, London, and elsewhere prohibited the trading of specific stocks. No other country automatically closes volatile markets for a breather.
C ritics of the new rules say that circuit breakers flopped in their NYSE debut. The first circuit breaker was thrown at 2:35 p.m. Monday, Oct. 27. After the 30-minute pause, trading resumed and the market dropped another 204 points in 25 minutes, triggering the second circuit breaker. The current Wall Street consensus is that the break made investors and traders even more inclined to sell, instead of cooling them off. Many traders blame the cable networks, which dwelt on the first circuit breaker and reported it as a sign of an impending crash. During the first lull, traders who had orders to sell by the end of the day were already anticipating a second circuit breaker. Fearing that a second circuit breaker would close the market for the day and prevent them from executing their orders on advantageous terms, they sold their stocks as soon as possible instead of waiting to find the best price.
Circuit-breaker critics also argue that the mechanism prevents the market from working itself out of a crash. Extreme volatility, they say, is a natural part of the market's quest for equilibrium between supply and demand. Interrupting this process causes additional drops such as Monday afternoon's, rather than upswings such as Tuesday morning's.
Technology has made moot much of the original justification for circuit breakers. Following the 1987 crash, both NASDAQ and the NYSE invested billions in expanding and automating the transaction infrastructure to accommodate the enormous swells in trading. The NYSE's computers now can handle the sale of 2.7 billion shares a day, vs. 440 million in 1987. Monday, 685 million shares were traded--not much more than the daily average volume of 528 million. But Tuesday, the NYSE handled a record 1.2 billion shares, with its central computer processing as many as 274 transactions a second. On both days, traders had no difficulty matching buyers and sellers and speedily filling orders.
The Securities and Exchange Commission and the NYSE originally devised the circuit breakers to kick in after a 250-point drop. At the time, 250 points represented 12 percent of the market's value. Adjusting for the quadrupling of the market over the last seven years, the SEC and the NYSE raised the circuit-breaker trigger last year to 350 points. Critics say that 350-point trigger is far too low, allowing the circuit breakers to flip at levels that don't warrant a stoppage of trade. They appear to be right. Monday, when the first circuit breakers were imposed, the market had dropped only 5 percent. SEC Commissioner Arthur Levitt Jr. has said that the circuit breakers should be reformed so that they are triggered by a drop in percentages, not points.