The impact of circuit breakers and program trading limits has been the subject of lively debate among market regulators, market administrators, professional traders and academics. The Chicago Mercantile Exchange ("CME"), which is far and away the world's largest regulated market for the trading of equity index futures contracts, has been at the center of developments and has an enormous stake in insuring that circuit breakers are used wisely and fairly.
CME's Role in Stock Index Futures Trading: In 1982, with the launch of the Standard & Poor's 500 (S&P 500) stock index, CME placed itself at the leading edge of stock index futures contract trading. In 1982, there were relatively few market participants who were familiar with stock index futures. However, within months, daily volume levels of more than 20,000 contracts established the value of the S&P 500 future. In 1997, the CMEE was the most active stock-index futures contract market in the world: 30 million equity-index-futures and futures-options contracts changed hands. The value of shares traded on a recent heavy day at the New York Stock Exchange ("NYSE") was $26 billion. During 1997, the CME traded 30 million equity-index-futures and futures-options contracts. The notional value of the S&P 500 futures contracts alone averaged $32 billion per day with mouth end open interest at $86 billion. Clearly, the CME has an enormous stake in insuring that circuit breakers are used wisely and fairly.
The S&P 500 is the quintessential benchmark for institutional portfolios invested in U.S. equities: more than $600 billion is directly indexed to its performance. More than two dozen countries have followed the CKE's lead in creating exchange-traded domestic stock index products. In the United States, 97% of stock index futures trading occurs at the CME, clearly making it the premier index exchange in the world. The CME provides markets where institutional ftmd managers and individual traders come to trade indexes on large-cap stocks, mid-caps, small-caps, and technology stocks. The broad variety of indexes available at the CME reflects the CME's commitment to the product line and customers' commitment to the CME.
Trading in the S&P 500 ffitures and options market has matured with the bull market in U.S. equities that also began in 1982. Five years later, the futures market proved it had staying power when it came through the October 87' "crash" with flying colors. The CME stayed open, relieving critical market pressures. In the aftermath, it became clear that the U.S. stock market was inextricably linked to and benefited by trading activity in stock index futures and options.
The price limits and trading halts developed jointly by the futures and securities industries following the 1987 crash were tested on October 27, 1997, as markets reacted to turbulence in Hong Kong. The coordinated circuit breakers at the CME and the New York Stock Exchange (NYSE), which resulted in multiple trading halts on October 27, worked smoothly.
S&P Index Basics: When the S&P 500 futures market opened in 1982, the underlying index value was about I 10 and the value of a single futures contract was near $58,000. Fifteen record bull-market years later, however, the S&P 500 index is at the 950 level.
The S&P 5 00 Index is considered the barometer of U.S. stock market performance by professional investors and is the benchmark against which their performance is measured. Tle S&P 500 represents a broad spectrum of companies in a variety of industries. The U. S. Commerce Department has included the S&P 500 index as the only measure of stock prices in its Index of Leading Economic Indicators since 1968.
Introduced in 1957, the S&P 500 Composite Stock Price Index was designed to represent the market value of 500 leading companies in leading industries. Accordingly, the S&P 500 has evolved into a large-cap index. At year-end 1996, the median market capitalization of the companies in the S&P 500 was $5.364 billion. The S&P 500 had a total market capitalization of $5.625 trillion, accounting for 69% of the market value of the more than 7,200 companies in Standard & Poor's internal database.
At the end of July 1997, industrial stocks accounted for about 80% of the total market value and covered the following industries: consumer staples, technology, health care, capital goods, consumer cyclicals, energy, communications and basic materials. Financial stocks equaled about 16% of the S&P 500 index value while utilities were 3% and transportation stocks were just over I%. Standard & Poor's has the responsibility for adjusting the index to account for stock splits and stock dividends, for example, to avoid index distortion. In each case, S&P modifies the index (through the divisor used to compare current to base value) between trading sessions. The index then remains at the same value on the opening of trading as it was at the prior close, and any performance difference is insignificant. Standard & Poor's acts independently of the CME in decisions regarding index maintenance.
A stock's influence on the S&P 500 index is related to its market value, which is determined by multiplying the number of shares outstanding by the share price. The resulting market values for all 500 firms are totaled and compared to that for the base period (1941-194' ) = 10) to derive the index value. Thus, a price change in any one stock will influence the index in proportion to the stock's relative market value. It is the market- value-weighting characteristic that has made the S&P 500 index the investment industry's standard for measuring the performance of actual portfolios.
CME Speaks for 95% of Futures Market Volume and Open Interest: The vast majority of industry participants and regulators accept the argument favoring enlarging the trigger points for trading halts, although the exact trigger points are open to legitimate question and compromise. The CME represents the view of the futures market most significantly impacted by circuit breakers and program trading limits. We have reviewed all of the academic studies, our well-qualified staff has conducted its own studies and we have sought out the opinions of market users and our distinguished outside directors and advisors.
The CME endorses the NYSE proposal for coordinated circuit breakers that halt trading for a brief period after a 10% price move and that stop trading for the day after a 20% move.
For reasons that should come as no surprise, the CME strongly opposes the program trading limits imposed by NYSE Rule 80A. In recent discussions, NYSE staff members have indicated that they intend to carefully review Rule 80A. The CME is optimistic that such review should result in repeal or substantial revision of Rule 80A.
Beginning in October 1988, the New York Stock Exchange (NYSE) imposed rules to limit index arbitrage and other forms of program trading in response to substantial market moves. 'fhe trading limit rules -- the Collar and the Sidecar -- imposed by NYSE Rule 80A include the following features.
Collar -- 50 DJ1A Points: On July 3 0, 1990 the U.S. Securities and Exchange Commission (SEC) approved amendments to NYSE Rule 80A. It had been adopted in October 1988 with a 75 index point "collar" on a voluntary basis. ]Me amendments introduced an index arbitrage tick test (commonly referred to as "Rule 80A") for program trades that became effective on August 1, 1990. Under the amended Rule 80A, when the Dow Jones Industrial Average (DJIA) moves 50 points or more from the previous day's close, index arbitrage orders in component stocks of the Standard & Poor's 500 Stock Index (S&P 500) are subject to a tick test. In down markets, sell orders may be executed only on a plus or zero-plus tick; in up markets buy orders may be executed only on a minus or zero-minus tick.1 The rule applies for the remainder of the day, unless the DJIA moves back within 25 points of the previous days close. The tick test can be (and has been) implemented multiple times on the same day. A program trade is defined as a basket of 15 or more S&P 500 stocks valued at $1 million or more.
As of October 18, 1990, market-on-close orders to liquidate previously established stock positions against expiring derivative products on expiration Fridays are exempt fi7om the index arbitrage tick restrictions of Rule 80A.
Sidecar - 12 S&P Points: When the CW's S&P 500 lead-month futures contract declines 12 points (approximately 100 DJIA points) from the previous day's close, all program trading market orders entered in SuperDot for NYSE-fisted component stocks of the S&P 500 are diverted to a separate blind file for five minutes. After the five-minute period, buy and sell orders are paired off and become eligible for execution. If orderly trading in a stock cannot resume, trading in that stock is halted and imbalance information will be publicly disseminated. New stop and stop limit orders in all stocks are banned for the rest of the day, except for those orders from individuals for 2,099 shares or less. The five-minute sidecar rule does not apply in the last 35 minutes of trading.
The five-minute sidecar was also adopted on October 19, 1988. At that time it was coincidentally triaaered at the same level as one of the CME's limits on the S&P 500 futures contract. However, the futures price limit was subsequently increased to 15 points. The NYSE did not increase the Sidecar limit.
Conditions have changed substantially since Rule 80A was adopted. In 1990, lack of computational power caused the NYSE considerable difficulty responding to large volume surges. Also, the index values were much lower than they are today. The Collar was set at 50 DJIA index points when the DJIA was less than 3000. In 1990, the average of the daily high-low range was 43.27 index points. The average daily range was 86.5% of the trigger. A move of 1. 72% from the previous close was required to trigger the Collar. In 1990 there were 23 Collar events or an average of one event in 4.7 trading days.
The DJIA is computed by adding the prices of 30 stocks and dividing by a divisor (most recently ".25089315") adjusted to keep the index consistent despite changes in component companies At today's DJIA level of about 7750 index points, the sum of the stock prices is $1944.42. In effect, each one-dollar price change in a component stock is multiplied by 4 to compute the change in the index. The 50 DJIA point move that triggers the Collar now represents a mere $.42 change in the price of each of the 30 stocks.
In 1997, the average daily range was 111.18 points -- 222.3 6% of the trigger. The Collar is now triggered by a mere .65% change in the index. Recently, the Collar was triggered seven minutes after the opening on a completely quiet day. It is not surprising that there were 303 Collar events on 219 of the 253 trading days in 1997. It may however be surprising to some that stock-return volatility, measured in percentage terms, was virtually the same in 1997 as it was in 1990.
The Sidecar experience is parallel. The average daily price range of the S&P 500 grew from 5.51 index points in 1990 (less than the trigger level) to 14.85 index points in 1997. When adopted the trigger was 4.27% of the S&P 500 index. Today, with the S&P 500 index at 950, the 12-point trigger is an insignificant 1.26% of the Index.
In 1990, one Collar or Sidecar event per week was the norm Now more than six events per week are standard. Even if it were conceded that the trigger levels were correct in 1990, it is certain that they cannot be appropriate in 1997.
The problem is compounded because Rule 80A events have come to be regarded , as a signal that the market is dangerously volatile. In an insightful essay on innumeracy at the popular "Motely Fool" website2 , Mark Brady takes to task the newscasters and Wall Street gurus who confuse volatility with trigger events.
We are seeing wide point swings in the Dow because the Dow is at a higher level. Let's say the Dow swings 1% a day. At 2400, this would be 24 points. At today's level of around 8000, thats 80 points. Either way, it is a I% swing. The Dow is nothing, but an arbitrary index, multiply it by 10 and we would expect to see point swings that are 10 times as large. The same is true of a stock price, you shouldn't care if a share is $25 or $250, all you should care about is what the percentage increase (or decrease) is.
The problem is that Rule 80A cares. The wise people from the NYSE who wrote this rule in 1990 did not understand numbers. If the Dow was at 2500, 50 points would have been a 2% move. The Iogical thing would have been to use a percentage rather than a flat number to trigger the circuit breakers. That two percent translates now to 160 points. Very few trading days have reached that nurnber this year. The rules, instead of decreasing the perception of volatility, have caused the talking heads to complain about all this increase in volatility and how the market must be riskier. It is working against what the rule was designed to do because the authors did not understand math. This is compounded by the fact that the talking heads who report on this are just as bad at figures.
The natural inquiry is why the NYSE has refused to revise the trigger levels to keep pace with changes in index levels. Surely, the capacity of NYSE market makers has not fallen in inverse proportion to the rise in index levels.
The New York Stock Exchange's stated purpose for adopting Rule 80A was to reduce market volatility and promote investor confidence. The academic studies undermine the claim that the Rule 80A limitations have those beneficial consequences.
The basis and persistence of the split between the economists' view and the views of certain segments to the business community is explained by Professor Dan Furbush as follows:3
"For program trading, econonuc theory and empirical evidence are so clear that economists--famous for their disagreements--are nearly unanimous 'M the view that program trading plays a relatively neutral role with respect to stock prices. This is one of the few issues on which even John Kenneth Galbraith and Merton Miller see eye to eye. Miller has noted, "The observed variations in day-to-day volatility [do not] seem to be much related to changes in the intensity of program trading." Meanwhile, Galbraith, in a discussion of the October 1987 market crash, called program trading a "superbly subordinate factor."
But finance practitioners do not all agree with the economists. The views of the brokerage community, expressed 'in testimony before Congress, in the popular press, and even on Super Bowl television commercials, show a contrast with the economists view that would be corm'cal for its hyperbole, if it were not dangerous for its misinformation. For example, David Wilson, head of Penn Mutual's stock portfolio, observed, "Program trading is almost like sitting on a calm beach and have [sic] a tidal wave hit you." A writer for Barrons called program trading "at best a parasite and at worst a cancer on the stream of useful business activity." And an editorial in Investors Daily explained the October 1987 crash by reporting, "Program traders turned ugly-- and the NYSE became a violent nuthouse." Full-page advertisements appearing in several national newspapers (and reported as news in one) bore the headline, "Never Have So Few Taken So Much From So Many." The ads continued, "The speculators and their political friends ruined the S&L industry. Now they have the power to ruin the stock market." Many people have accepted such statements as true, although the statements generally have come from sources whose business interests are challenged by innovations such as program trading.
So, economists and many practitioners disagree. But imvestors are the folks who matter. For the most part, 'individual 'investors are both uninformed and unconcerned about program trading.
The most probable impact of Rule 80A, which is directed at professional arbitrageurs, is to increase the costs of their trading. The imposition of such costs tends to increase transitory volatility and uncouple NYSE and CME markets. Each time Rule 80A is invoked, two markets that ought to be closely interlinked are artificially separated. Market information, which is often first expressed as price change in futures markets, is restrained from flowing freely to the stock market and its public investors. That net loss of information directly disadvantages public investors.
In addition, Rule 80A directly interferes with arbitrage between the two markets in a manner that reduces trading opportunities in Chicago. A striking impact on trading is experienced by the CME when Rule 80A is triggered. Academics4 calculate the loss of business in the range of $100,000,000 in notional value each time Rule 80A is triggered. Given the regularity of triggering events, the diversion of business from the CME is in the range of $25 billion annually.
The CME has clearly expressed its concerns regarding Rule 80A directly to the NYSE. We have every reason to believe that these questions will be given the attention they deserve at a very early date after the Rule 80B issues have been resolved.
History and Content: In October 1988, one year after the 1987 crash, the NYSE and other securities exchanges adopted trading halt and price limit rules. NYSE Rule 80B halted trading for one hour if the DJIA declined 250 points. A 250-point decline was approximately 12% of the Index. K after the market reopened, the DJIA fell another 150 points, trading was halted for two hours. These trigger points, which roughly followed recommendations from the President's Working Group, were never hit. However, in March of 1996, when the trigger was closer to 6% of the Index, the market flirted with the 250-point trigger. Effective July 22, 1996, the first halt was shortened from one hour to 30 minutes and the second from two hours to one hour. On February 3, 1997, the initial trigger point was raised to 350 points and the second trigger was raised to 550 index points. At current market levels, the initial trigger is approximately 4.53% of the DJIA and the second trigger is about 7% of current Index levels.
In a paper presented at a Vanderbilt Law School retrospective on the crash of 1987, "Setting NYSE Circuit Breaker Triggers," GeofRey Booth and John Paul Broussard, examined the statistical distribution of extreme price changes in the Dow Jones Industrial Average. They concluded that the failure to adjust the fixed-point circuit breaker will result in many more market shut-downs than initially contemplated. The 250- point circuit breaker initially represented a decline of about 12% in the Dow, an event that could be expected about every I I years. Even the new 350-point circuit breaker implemented in early 1997 represents a decline of only 5%, an event that can be expected every 172 days.
On October 27, 1997, the 350-point trigger was hit at 2:35 p.m_ and the 550-point limit was hit soon after the market reopened at 3:05. This trading halt closed the market for the day. In December the NYSE Board proposed modifications to Rule 80B that would shorten the 550 point halt to 30 minutes if triggered after 2 p.m. If triggered after 3 p.m. trading would not resume. These changes have been approved by the SEC and will be implemented, in coordination with futures markets, on February 2. The 350-point circuit breaker would be removed after 3 p.m Newspaper reports suggest that the NYSE is considering floating the trigger points with the index level to keep the triggers close to 10 and 20 percent. The relevant exchanges are in the process of forging a uniform position on this proposal.
The CME also adopted price limit rules for its equity index contracts. These price limits were coordinated with the NYSE Rule 80B trading halts when the latter were adopted in 1988. The price limit structure and levels have changed several times as the Exchange has gained more experience. As the level of the underlying market has continued to rise, the limits have been altered accordingly.
The CME currently has eight domestic equity index futures contracts listed for trading, each with its own price Emit rules. The CME's current rules stipulate the following structure for each futures contract:
For overnight trading on GLOBEX the CME imposes a price limit equal to the first intermediate price limit that will be in effect on the next trading day.
The October 27, 1997, 70-point slump in the S&P futures price represented a 7.42 percent market decline - far smaller than the 28.61 percent decline of the 80.75-point move on Oct. 19, 1997, when the S&P Index level was closer to 300. The market opened lower on October 28th, but then moved up 50.50 points. This was the biggest S&P point gain ever, surpassing the 42-point jump on Oct. 21, 1987.
CME price limits and trading halts were activated multiple times during the October 27t" 70-point decline. For the first time, trading halted at the 45-point and 70- point levels, corresponding to 350 and 550 DJIA points on the NYSE. The CME Clearing House moved a record $3.7 billion through the Fedwire system in Mondays "mark-to-market" -- $1.2 billion more than during the crash of 1987 -- without encountering credit problems.
Economic Theories: The literature is replete with economic theories for and against trading halts and price limits. Most have been advanced at CME Board meetings when we periodically consider the issue. Some of the more prominent theories are as follows:
Pro Limits and Halts:
Contra Limits and Halts:
CME director, Nobel Laureate Merton Miller, confronts the value of price limits and trading halts from the perspective of the futures and securities markets in his book, Financial Innovations and Market Volatility, Cambridge:Blackwell (1991). Miller notes that price limits are a standard feature of the futures industry and the " natural (in the sense of least-cost) institutional response by the industry to two problems that large sudden price changes pose for its particular trading, clearing, and settlement technology." P.235 He notes that halts at the NYSE permit it to depart from its "price continuity" trading standard under extreme circumstances. The halt and reopening converts the NYSE continuous market into a call market with the potential for discovering an equilibrium price.
Miller concludes that circuit breakers meet organizational needs in futures and securities markets. He stresses, however, that coordination between linked exchanges is essential.
The academic studies are sufficiently mixed and questioned that they do not serve to decide the argument. On balance, price limits and trading halts seem to benefit informed traders while frustrating those traders most likely to contribute to the transitory volatility that is least associated with flindamental information. If the theory were correct, limits and halts would have a legitimate place in market regulation. To the contrary, the Collar and Sidecar of Rule 80A more likely increase transitory volatility because of their negative impact on informed traders for the benefit of uninformed traders. Rule 80A restrictions do not have a legitimate role in a neutral regulatory program
The CME is responsible for matching all of the trades and guaranteeing all of the resulting positions in the world's largest and most active equity index futures contract. In addition, the CME's clearinghouse guarantees options on its futures contract. The Brady Commission, the SEC and the GAO all responded to the 1987 crash by concluding that circuit breakers were an appropriate response to the pricing inefficiencies and increased costs caused by extreme demand on equity market capacities during large, rapid price movements. The CME believes that time-outs imposed by coordinated circuit breakers will increase the flow of information to the market, save costs and reduce risks to market participants that are related to time constraints. The trading delay will:
If all parties are fully informed in advance of the rules imposing trading halts and
limits, they can be expected to evolve trading strategies appropriate to the playing field.
The CME believes that correctly set trading halts and price limits are appropriate.
1 A zero-plus tick is a price equal to the preceding sale if the last transaction at a different price was at a lower price.
3 Furbush Dan, "Program Trading in Context: The Changing Structure of World Equity Markets," Regulation, 1991, v14 (2)
4 James Overdahl and Henry McMillan, "Another Day, Another Collar: An Evaluation of the Effects of NYSE Rule 80A on Trading Costs and Intermarket Arbitrage," OCC Economics Working Paper 97-8 (May 1997).
5 Sanford Grossman paraphrased in Miller, Financial innovations and Market Volatility 236 fn 9
(Cambridge: Blackwell 1991).
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