I am pleased to appear before the Senate Subcommittee on Securities to discuss the Treasury Department's views on "circuit breakers" -- the name commonly given to coordinated trading halts in the equity and equity-derivative markets that are required when large price moves of predetermined magnitude occur. We believe that the leadership this Subcommittee has provided on this important issue concerning the functioning of our financial markets in time of crisis has served to focus the attention of interested parties in a very constructive way.
The subject of circuit breakers is not free from controversy. There are sharply differing views as to whether the triggering of a trading halt would have a beneficial effect when there is a major decline in equity prices. At the outset, therefore, it may be useful to frame the discussion of circuit breakers by briefly summarizing the arguments pro and con.
Those who believe that circuit breakers are appropriate make the following points:
On the other hand, those who believe that circuit breakers are inappropriate suggest that:
There is weight to the views on each side, and there is no clear consensus. It seems beyond dispute, however, that any attempt to engineer rules to prevent the market from reaching its natural level is doomed to fail. In any event, as the market self-regulatory organizations and their regulators deliberate the appropriateness of changes to the current rules relating to circuit breakers, we believe the following principles should guide those deliberations:
Against the background of these principles, it may be instructive to review why the President's Working Group on Financial Markets originally proposed coordinated trading halts, as well as developments since their adoption.
Circuit breakers were one of the reforms implemented in reaction to the stock market decline of October 19, 1987, a day that the Dow Jones Industrial Average ("Dow") fell by a record 22.6%. This percentage decline in the Dow exceeded by a large margin the previous record one-day fall, the 12.8% decline on October 28, 1929.
The historic drop in October 1987 gave rise to numerous studies and to the creation of the President's Working Group on Financial Markets, which is chaired by the Secretary of the Treasury. The Working Group submitted a report to the President in May 1988, which recommended, among other measures, the establishment of coordinated trading halts in the exchange-traded equity and equity-derivative markets. The recommended trigger points for these circuit breakers were 250 and 400 point declines in the Dow, with a first halt of one hour and a second halt of two hours. These were subsequently adopted. At the time of the recommendation, these trigger points represented movements in the Dow of approximately 12 and 20 percent, respectively.
The basis for the Working Group's recommendation for coordinated trading halts was the view that this type of automatic halt was preferable to "unplanned, ad hoc trading halts," which would otherwise likely take place during dramatic market events and which would have the potential to be destabilizing.
In the May 1988 report, the Working Group also recommended that these trigger points "be reviewed at least quarterly to determine if changes in index levels necessitate changes to these triggers in order to maintain percentages approximately equivalent to 12% and 20%." However, it was not until January 1997 that the trigger points were increased from 250 and 400 Dow points to the current 350 and 550 points, which at that time represented approximately 5.2% and 8.2% declines in the Dow, respectively. At current market levels, these point declines would represent moves of approximately 4.5% and 7%. The duration of the halts was also reduced in 1997 to 30 minutes and one hour, respectively.
The current focus on circuit breakers was prompted by their being triggered for the first time on October 27, 1997, just 10 years after the 1987 market fall. On that day last October, the 350-point 30-minute circuit breaker was triggered at 2:35 pm. After the market reopened at 3:05 pm, it took just 25 minutes for the second 550-point circuit breaker to be tripped at 3:30 pm, which closed the market for the rest of the day. The market's premature close was thus caused by a 7.2% decline, which, while significant, was well below the 12% and 20% levels that the original Working Group proposal had contemplated.
Many market participants and observers have expressed dissatisfaction with this first experience with circuit breakers. While there were no major operational problems on October 27, 1997, or on subsequent trading days, many believe that the circuit breakers were triggered by point moves that were much too small, given the level of the Dow. Also, given the rapidity with which the market hit the second circuit breaker, many believe that the second breaker had a "magnet" or "gravitational" effect, accelerating the decline as market participants hurried to sell their positions before the market closed again.
The President's Working Group on Financial Markets, at the request of Chairman Gramm and Ranking Member Dodd, is currently reviewing this recent experience with circuit breakers. Our analysis of that day's events has not been completed. Nevertheless, the stock market's performance on October 27 was not an event of the magnitude that the Working Group originally envisioned as requiring an automatic cessation of trading.
The rise in the level of the stock market over the past 10 years would be reason enough to increase significantly the point drops that trigger the circuit breaker trading halts. There is another reason, however, for increasing the trigger levels. In 1987, the market infrastructure was severely strained by the volume of trading that was experienced. Under these circumstances, a trading halt might have been justified simply to allow the markets to keep pace with the flow of the workload. Today, the stock market is far better equipped to handle large market moves accompanied by high trading volume, due to the impressive increase in system capacity that has occurred over the past decade.
In October 1987, the New York Stock Exchange's theoretical capacity was 440 million shares per day, about 2.3 times the average daily volume on the NYSE in 1987. On October 19 and 20, 1987, volume on the NYSE exceeded theoretical capacity, with more than 600 million shares changing hands on each of those two days. This led to system problems and information gaps when it was impossible for anyone not on the trading floor to know the price at which the last trade in a particular stock was transacted.
By contrast, the NYSE's current capacity is 2.5 to 3 billion shares per day, or about five times the average daily volume. At the peak volume in message traffic on October 28, 1997, system capacity was approximately double actual usage. Unlike the situation in October 1987, there were no reporting delays.
This increased system capacity, a result of the heavy investment the NYSE has made in technology, for which the Exchange should be commended, means that one of the reasons given by the Working Group in 1988 for planned trading halts -- the potential for system breakdowns -- is less compelling today. While problems are of course still possible, the increased capacity means that system breakdowns at the NYSE are less likely than they were a decade ago.
The New York Stock Exchange reportedly will consider next week a proposal that would reset the circuit breaker trigger points twice a year at a fixed number of points representing 10% and 20% of the market level. Under this proposal, a 10% fall in the Dow prior to 1:00pm would trigger a one hour halt in trading. If such a fall occurred between 1:00pm and 2:30pm, the halt would be limited to 30 minutes, and if it occurred after 2:30pm it would shut the market for the remainder of the day. A 20% fall would close the market for the day whenever it occurred.
The Treasury Department would view the proposed changes in the trigger points as an improvement over the current rule, but we believe other aspects of the proposal are inconsistent with the principles we have described. The rationale for doubling the duration of the first trading halt, returning to the 1988 formulation, is not clear. Since we have had a recent occasion on which a 30-minute halt was triggered by the first breaker, it is reasonable to expect that a proposal for such an increase would be accompanied by a compelling factual case, grounded in actual experience, justifying such a lengthening of the halt. Beyond this, we would have substantial concerns about any rule that would result in a complete shutdown of the market, precluding a normal closing perhaps many hours before the scheduled close. We would urge that the most careful thought be given this proposal, including not only an analysis of the effects on market participants, but on public confidence in the market and on the potential spillover effects on foreign markets as well.
As our suggested principles indicate, we believe that a conventional market close, set by the clock, is preferable to a close prematurely triggered by a price limit. A conventional close enables mutual funds to use real market prices to calculate their net asset values, provides real benchmarks for portfolio managers, lessens the disruptive impact on foreign markets, and does not cause problems with respect to contracts that key off closing prices for valuing securities, such as those under which business combinations are carried out. Such a result could be achieved if the circuit breaker rules were written so as to permit the markets to be open for at least the hour before the scheduled close.
The Treasury also believes that not only the circuit breaker rules but the "collar" and "sidecar" rules need to be revised or eliminated. The collar rule, which is activated by a 50-point move in the Dow, up or down, restricts all index arbitrage orders, whether entered into the NYSE's computerized order system ("SuperDot") or brought manually to the specialists' posts, to execution on a plus or zero-plus tick in down markets or on a minus or zero-minus tick in up markets. The sidecar rule delays for five minutes the transmission of all program trades entered into SuperDot when the S&P 500 futures contract has declined 12 points (approximately 100 Dow points). These rules have the effect of slowing down arbitrage between the futures and cash markets by effectively throwing sand in the gears. The collar rule has become particularly inappropriate; given that a 50-point move in the Dow, up or down, is currently a frequent occurrence, this rule is now activated more times than there are trading days. These rules have nothing to do with mitigating the fallout from a dramatic market situation, and they should be reconsidered.
We appreciate the opportunity this Subcommittee has provided to present our views on
this important topic.
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