The NASD has, since 1988, consistently believed that circuit breakers should, at most, be used in response to extraordinary price movement. The NASD's prefers the markets to stay open wherever possible and believes that it is especially important that they be open at the end of the day.
The NASD believes that circuit breakers which tripped for the first time on Monday, October 27, 1997 need to be substantially expanded to 10% and 20% drops of the Dow Jones Industrial index (DJIA) for at least two reasons:
First, 350 points of the DJIA (where the circuit breakers now trip) is not what it used to be. Years ago when circuit breakers were initially set, it took a 12% market drop to trip them; on Monday, October 27, 1997, the 350-point shut-down came on only a 4.5% drop. Worse yet, a second system-wide halt on only an additional 3% drop appeared to actually increase price volatility.
Second, the rationale for having circuit breakers was to provide a breathing space only where the market drop was so great that there were legitimate concerns regarding the creditworthiness of contra parties and there were no buyers appearing at any price. Taking away all liquidity just when investors needed it most had very negative repercussions both on Monday afternoon and the Tuesday, October 28, 1998 opening.
We have been working with the SEC and the other markets on circuit breakers, which has resulted in proposals with the following two aspects. First, the proposals would deal with the present concerns by increasing the circuit breakers from 350 and 550 DJIA drops to 10% and 20%. Second, there has been a great deal of discussion on the implications of restarting the markets after a circuit breaker has been tripped.
We see a clear consensus among markets and market participants on increasing the circuit breakers from their current 350 and 550 DJIA levels to 10% and 20% drops instead. We are very concerned, however, with any proposal that would result in the markets prematurely closing for the remainder of the day because a circuit breaker is hit. While we do not minimize the impact of such large price movements, we believe that the potential adverse impacts on market confidence and price volatility of closing for the day are likely to be worse than attempting to reopen the market.
While we are thus not in complete accord with all of the changes that are being
discussed, we strongly support taking action to update the circuit breakers to 10% and 20%
limits as soon as possible. Indeed, this step is so critical that the NASD would support any
reasonable solution regarding the circuit breaker reopening issue to avoid further delay.
I am Richard Ketchum, Executive Vice President and Chief Operating Officer of the National Association of Securities Dealers.
The NASD would like to thank the Subcommittee for this opportunity to testify on the role of circuit breakers in the operation of the U.S. securities markets.
Your invitation letter asked for our evaluation on whether circuit breakers were a stabilizing or destabilizing influence on the markets, including any impact on the international markets, as well as comments on proposed changes to the circuit breakers.
In summary, the NASD is of the view that circuit breakers which tripped for the first time on Monday, October 27, 1997 need to be substantially expanded to 10% and 20% drops of the Dow Jones Industrial index (DJIA) for at least two reasons:
First, 350 points of the DJIA (where the circuit breakers are set to "trip") is not what it used to be. Years ago when circuit breakers were initially set, it took a 12% market drop to trip them; on Monday, October 27, 1997, the 350- point shut-down came on only a 4.5% drop. Worse yet, a second system-wide halt on only an additional 3% drop appeared to actually increase price volatility.
Second, the rationale for having circuit breakers was to provide a breathing space only where the market drop was so great that there were legitimate concerns regarding the creditworthiness of contra parties and there were no buyers appearing at any price. Taking away all liquidity just when investors needed it most had very negative repercussions both on Monday afternoon and the Tuesday, October 28, 1998 opening. The use of circuit breakers, especially after relatively small percentage breaks, is to us more questionable than ever.
The NASD has consistently believed that circuit breakers should, at most, be used in response to extraordinary price movement. As I will describe in my testimony, we have questioned them from their implementation. Our views today are merely a continuation of our original position, updated by the experience of the circuit breakers tripping last October, and the passage of time that has seen a more than tripling in the DJIA since the circuit breakers were first linked to that index in 1988.
Let me briefly outline the role of the NASD in the regulation and operation of our securities markets. Established under authority granted by the 1938 Maloney Act Amendments to the Securities Exchange Act of 1934, the NASD is the largest self-regulatory organization for the securities industry in the world. Every broker dealer in the U.S. that conducts a securities business with the public is required by law to be a member of the NASD. The NASD's membership comprises more than 5,500 securities firms that operate in excess of 62,000 branch offices and employ more than half a million registered securities professionals.
The NASD is the parent company of The Nasdaq Stock Market, Inc and NASD Regulation, Inc. (NASDR). These wholly owned subsidiaries operate under delegated authority from the parent, which retains overall responsibility for ensuring that the organization's statutory and self-regulatory functions and obligations are fulfilled. The NASD is governed by a 27-member Board of Governors, a majority of whom are non-securities industry affiliated. Board members are drawn from leaders of industry, academia, and the public. Among many other responsibilities, the boards, through a series of standing and select committees, monitor trends in the industry and promulgate rules, guidelines, and policies to protect investors and ensure market integrity.
In keeping with the NASD's mission of facilitating capital formation for the ultimate benefit of investors, the Nasdaq Stock Market develops and operates a variety of market systems and services. The Nasdaq Stock Market is the largest electronic, screen-based market in the world, capable of handling trading levels of at least one and a half billion shares a day. Founded in 1971, Nasdaq today accounts for more than one-half of all equity shares traded in the nation and is the second largest stock market in the world in terms of the dollar value of trading. It lists the securities of more than 5,500 domestic and foreign companies, more than all other U.S. stock markets combined.
NASD Regulation is responsible for the registration, education, testing, and examination of member firms and their employees. In addition, it oversees and regulates our members' market-making activities and trading practices in securities, including those that are listed on The Nasdaq Stock Market and those that are not listed on any exchange.
NASDR carries out its mandate from its Washington headquarters and 13 district offices located in major cities throughout the country. Through close cooperation with federal and state authorities and other self-regulators, overlap and duplication is minimized, freeing governmental resources to focus on other areas of securities regulation.
NASDR has examination responsibilities for all of its 5,500 members. In addition to special cause investigations that address customer complaints and terminations of brokers for regulatory reasons, NASDR has established a comprehensive routine cycle examination program.
In March 1988 the President established the Working Group on Financial Markets to respond to the October 1987 market break. The group consists of the Under Secretary for Finance of the Treasury and the Chairmen of the Securities and Exchange Commission, Commodity Futures Trading Commission, and the Board of Governors of the Federal Reserve System. The President charged the Working Group to determine the need for coordinated regulatory actions to strengthen the nation's financial markets.
Responding to October 19, 1987's DJIA decline of over 22.6%, the Interim Report of the Working Group recommended that, in periods of rapid market decline that threaten financial panic, trading halts and reopening procedures be coordinated among all U.S. markets for equity and equity related products: stocks, individual stock options, stock index options, and stock index futures. These pre-determined, coordinated, cross-market trading halts would address market drops that threaten ad hoc and destabilizing market closings.
The Working Group was concerned that these circuit breakers not be tripped prematurely and said that they should be set "broad enough to be tripped only on rare occasion, but sufficient to support the ability of the payment and credit systems to keep pace with extraordinary large market declines." It recommended a first circuit breaker level to be set at a 250-point decline in the DJIA, with a second level set at 400 points. At the time, these two levels of extraordinary decline in the DJIA were 12% and 19%.
The Interim Report cautioned that the circuit breaker levels must be reviewed by regulators and adjusted to continue to provide market wide halts only for extraordinary market breaks.
On September 20, 1988 the NASD Board of Governors reacted to the circuit breaker recommendation of the Working Group Interim Report, and issued its Market Closing Policy Statement, which it continues to support today, and which is part of The Nasdaq Stock Market's Marketplace Rules.
With regard to circuit breakers in particular the Board stated:
The Board strongly believes that the nation's securities markets should remain open and operating during normal market hours whenever possible.
The Board of Governors acknowledges that the risks imposed on any single market remaining open while all other U.S. markets have halted trading because of extraordinary price movements could be unacceptable. The Board therefore has determined that, at times when other major securities markets initiate market wide trading halts in response to extraordinary market conditions, the NASD will, upon request from the Securities and Exchange Commission, act to halt domestic trading in all securities quoted in The Nasdaq Stock Market and domestic trading in equity or equity related securities in the over the counter market.
This Policy Statement, which was originally issued until 1989, was subsequently extended each year until 1995, when it was extended to the present.
On March 8, 1996 a market drop of 216 points of the DJIA came close to triggering the 250-point circuit breaker. Although a 250-point drop in 1988 was 11.7% of the DJIA, growth in the markets since then meant that that same 250-point drop would then represent only a 4.5% decline. Market conditions on March 8 included volume that was less than heavy (587 million shares on Nasdaq), no disorderly trading or market confusion, no panic selling, and no catastrophic market or economic news. Circuit breakers that were designed to trigger in extraordinary markets came close to triggering in an ordinary market, closing all markets and potentially creating turmoil that they were designed to prevent.
NASD CEO Joseph Hardiman wrote to SEC Chairman Arthur Levitt on March 11, 1996 to request that the President's Working Group consider amendments to the circuit breakers. That letter requested:
In July 1996 the SEC approved proposals by each of the markets to shorten the time periods that the circuit breakers would halt trading. The original circuit breakers linked the 250-point DJIA drop to a one-hour halt and the 400-point drop to a two-hour halt. The 1996 action cut those time periods in half. In granting the reduction in the time periods, the SEC noted improvements in technology and market capacity and the enhanced ability of participants to learn of and act on large price movements in a short time.
In February 1997 the SEC approved changes in the circuit breakers to raise them from 250 and 400 point drops in the DJIA to 350 and 550 drops. The changes were made in the context of rule changes by the New York Stock Exchange, the American Stock Exchange, the Chicago Board Options Exchange, the Chicago Stock Exchange, the Boston Stock Exchange, and the Philadelphia Stock Exchange.
The Nasdaq Stock Exchange, Pacific Stock Exchange and Cincinnati Stock Exchange have general rules that require them to halt during intermarket circuit breakers and so did not need rule changes to match the new circuit breaker levels.
In the release granting the approval of the changes, the SEC noted that it consulted with the President's Working Group, which supported the raising of the circuit breaker triggers. It also stated:
On October 27, 1997 at 2:35 p.m., circuit breakers were activated for the first time ever when the DJIA fell 350 points, thereby initiating a thirty-minute trading halt. When trading resumed at 3:05 p.m., the DJIA continued to fall reaching the second circuit breaker level of 550 points at 3:30 p.m., which began a one hour trading halt that, since it occurred with only thirty minutes left of trading, closed all U.S. markets for the remainder of the day.
The markets remained robust even on large volume, with Nasdaq and the New York Stock Exchange processing more than 4 billion shares over the two days of October 27 and 28. Markets remained continuous and orderly, with dealers standing by their bids so that even the largest institutional investors were able to sell with minimum disruption. Quoted spreads and depths changed only nominally, market makers fulfilled their quote obligations and frequently "stepped-up" in size to provide additional liquidity to investors. Market makers actively supported the market; for example, the top few market makers took on net positions of over $250 million each day opposite the prevailing demand, providing constant liquidity.
Market reopenings after a halt are especially problematic. In spite of the large drop on Monday, October 27 and the substantial overnight uncertainty, Nasdaq opened all stocks on time on Tuesday morning with excellent price discovery, low volatility relative to other US markets, and relatively normal depths, reinforcing investor confidence.
In short, the 350 point circuit breaker halted the markets while they were still operating in an orderly manner; sellers were able to reach buyers and quotation spreads which increased only 11.5% despite the market stress were reasonable
Frank Zarb, NASD President Chief Executive Officer and Chairman of the Board noted that "Circuit breakers did nothing to change the market's direction, and in fact, may have contributed to anxiety creating a little bit of chaos."
Even worse, the combination of the nearness of the 550 point second circuit breaker with the fact that once reached, the market would be closed for the day, appeared to actually accelerate selling and increase the speed of the decline. While it took over five hours for the market to drop the 354 points before the first circuit breaker tripped, it fell the 200 points to the second circuit breaker in only 25 minutes close to 7 times faster.
The SEC called a meeting of the financial markets on circuit breakers on November 21, 1997, and has been working with each of the markets to resolve issues regarding the circuit breakers since then. The NASD would like to commend the SEC for the role that it is taking to ensure that fast and appropriate changes are made to the circuit breakers. It is clearly working to improve the current circuit breaker mechanism toward the best interests of the investor and the markets.
The only change to circuit breakers that has been officially proposed since then is a temporary proposal of the New York Stock Exchange, affecting how the circuit breakers are to work if they trip late in the day. That proposal, approved January 26, 1998 for February 1 through April 30, 1998, would modify current rules to halt trading on the NYSE:
The NASD's prefers the markets to stay open wherever possible and believes that it is especially important that they be open at the end of the day. We have been working with the SEC and the other markets toward solving the problems that were encountered last October, and we continue to stress the need to significantly increase the levels at which the circuit breakers will trip as soon as possible.
There are two aspects to the proposals being addressed by the markets. First, the proposals would deal with the present concerns by increasing the circuit breakers from 350 and 550 DJIA drops to 10% and 20%, respectively. Second, there has been a great deal of discussion on the implications of restarting the markets after a circuit breaker has been tripped. In that connection, there has been substantial sentiment among some markets that the 20% circuit breaker should trigger a halt of trading for the remainder of the day and the 10% circuit breaker should end trading for the remainder of the day if it occurs after 2:30 p.m.
We see a clear consensus among markets and market participants on increasing the circuit breakers from their current 350 and 550 DJIA levels to 10% and 20% drops instead. We believe that this action would redirect circuit breakers to their intended purpose a brief pause during periods of extraordinary price volatility. We are very concerned, however, with any proposal that would result in the markets prematurely closing for the remainder of the day because a circuit breaker is hit. While we do not minimize the impact of such large price movements, we believe that the potential adverse impacts on market confidence and price volatility of closing for the day are likely to be worse than attempting to reopen the market. In simplest terms, markets should be open, if at all possible, at the end of the day.
While we are thus not in complete accord with all of the changes that are being discussed, we strongly support taking action to update the circuit breakers to 10% and 20% limits as soon as possible. Indeed, this step is so critical that the NASD would support any reasonable solution regarding the circuit breaker reopening issue to avoid further delay.
The NASD thanks the Subcommittee for this opportunity to discuss the serious issues presented by circuit breakers as they currently exist. We are actively participating in the SEC's forum of markets now discussing what changes are needed to update circuit breakers.
We support open markets and reopening them if they close. It is clear that the current 350 and 550 point DJIA levels now set must be raised to the 10% and 20% levels that have been proposed. Delay in these changes risks a repeat of the October 1997 experience of orderly markets prematurely closed, creating needless investor anxiety. We support action to make those changes a reality at the earliest possible time.
I would be pleased to answer any questions you may have on my
testimony or the NASD's views on circuit breakers.
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