My name is Edward J. Joyce. I am Executive Vice-President, Trading Operations, for the Chicago Board Options Exchange. In that capacity, I am responsible for the management of the trading process at CBOE. I am pleased to appear before the Subcommittee this afternoon to present CBOE's views about current circuit breaker procedures and about how circuit breakers should be improved to ensure that they are a force for stability and fairness in the financial markets.
Although there is much debate on the issue, CBOE believes that circuit breakers on balance are a valuable tool that can help stabilize the financial markets during periods of precipitous market decline. In CBOE's judgment, the deciding factor is the need to promote public confidence in the stability of the financial markets. Steep market declines undermine confidence in the financial markets, but public confidence is bolstered by the knowledge that the markets will take a coordinated "time out" at some predetermined price levels. Because public confidence is of such paramount importance, CBOE supports the continuation of circuit breakers.
It is important, however, to refine and improve circuit breakers in response to changing circumstances and further examination of the issues raised by circuit breakers. First, current circuit breaker thresholds trigger trading halts at too early a point. It is a serious matter to close any market, much less all markets. Trading halts lock some investors Into potentially risky positions and deprive other investors of the opportunity to take potentially profitable market action. Although investors may welcome the breather that circuit breakers provide, they also fear the fact that circuit breakers may lock them into their positions. As demonstrated by the recent experience on October 27, 1997, circuit breakers therefore exert a "gravitational pull" on the market as the market approaches circuit breaker trigger levels. Aware that a circuit breaker is about to deny them access to a declining market, market participants are driven to sell while they still can access the market. Unless circuit breakers triggers are set carefully, they therefore may create the very panic they are designed to prevent,
One measure of whether it is time to impose circuit breakers is the extent to which individual financial markets are already showing signs of distress beyond a mere decline in market value. When a market decline causes problems beyond what the financial markets are able to handle, one of the sure indications will be that exchanges independently begin to halt trading in stocks, because order flow imbalances have become extreme or because those markets have ceased to trade in a fair and orderly manner. The proper role of a well-designed circuit breaker should be to promote a coordinated and organized process of market closure that already has begun to occur naturally.
Judged by this test, it is apparent from the experience on October 27, 1997 that current circuit breakers are triggered too soon. Be. I re the 350 point circuit reaker was triggered on that day, markets had been trading fluidly and without any apparent panic, There was no objective reason to believe that market participants required a "breathing space" before they could continue. Instead, all indications were that, but for the 350 point circuit breaker, markets could and would have continued to trade in a fair and orderly manner. In addition, the experience on October 27 demonstrates that the present 550 point circuit breaker is too close to the 350 point level. In a dramatic demonstration of the gravitational pull exerted by a circuit breaker that triggers too early, the market plummeted from the 350 to the 550 point level within just 30 minutes after the end of the 350 point trading halt.
The problem with the current circuit breaker levels is that they have failed to keep up with the increase in the value of the stock market over the years. Given current market levels, the 350 point and 550 point levels represent too small a market decline to justify a mandated market-wide trading halt. Instead of basing circuit breakers on the absolute size of a market decline, it would be more appropriate periodically to set the circuit breaker trigger levels in a percentage relationship to the Dow Jones average. In this manner, the trigger levels would not be rendered either too high or too low because of market movement over time. CBOE therefore endorses the proposal that those trigger levels be established at levels of IO% and 20% of the Dow Jones average.
Second, there are special considerations that justify a modified approach to circuit breakers when the trigger point is reached near the end of scheduled trading. In particular, circuit breakers can cause especially disruptive effects if they leave too little time to trade after the halt is lifted or if they have the effect of closing markets for the remainder of the scheduled trading day. Even under non-nal trading conditions, investors and other market participants need a meaningful opportunity to adjust their stock positions before the scheduled end of trading. This need is even more acute when the stock market is declining rapidly. In addition, unless there is a meaningful opportunity for the stock market to reach a closing level through trading, closing prices for stocks will not accurately reflect the equilibrium value for those securities. This has a serious indirect effect on options, other derivative products and even mutual funds, all of which base their value on closing stock prices. In short, circuit breakers can be seriously destabilizing if they prevent financial markets from closing through a meaningful period of trading before the scheduled end of the day.
To address these end of day concerns, the application of the 10% circuit breaker should vary depending on when in the trading day the trigger level is reached. The rule should be constructed so that, whenever possible, all market participants have an opportunity to engage in actual trading for a meaningful period of time (probably at least 60 minutes and preferably 90 minutes) after a circuit breaker threshold has been reached. The unacceptable alternative would be a nominal reopening after a trading halt, where the fairness of the process would be seriously compromised. The only thing worse than no market is an unfair market. Consequently, if there are circumstances under which it would not be feasible to provide a meaningful trading period after a circuit breaker halt, the only appropriate course of action would be for the markets not to reopen at all for the rest of that day after such a halt.
The final issue that requires attention is the need to ensure that markets respond
to circuit breakers in a coordinated fashion. The real value of a circuit breaker trading halt
derives from the fact that it is collective, uniform and coordinated across all markets. In any
reexamination of circuit breakers, it is important to ensure that there are not variations in the
circuit breaker rules of the various markets that may create the potential for divergent and
uncoordinated approaches to trading halts once circuit breaker levels have been triggered.
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