Halting trade in the world’s stock markets because of plunging share prices used to be a once-in-a-generation event. No longer.
U.S. stock trading was stopped twice last week to give panicky investors a 15-minute breather just as coronavirus pandemic fears drove markets into free-fall. The last and only previous time the so-called “circuit breaker” time-out went into force was back in 1997.
The U.S. was hardly alone. Last week’s global rout triggered circuit-breaker moments on stock markets in the Philippines, Thailand, Indonesia and India. And in Brazil, the benchmark Bovespa index stock market was halted twice on Thursday.
The rules differ by exchange on what has to happen in order to trigger the stop-trading order.
In the U.S., circuit breakers first kicks in when the S&P 500 drops by 7% in a session. In India, the Philippines and Thailand, trading is temporarily halted when the local benchmark index drops by 10% and in Indonesia when it falls 5%.
Why Europe doesn’t call a full time-out
In Europe, where some of the most volatile trading occurred last week, there are no market-wide or index-linked circuit breakers. So, when Italy’s FTSE MIB fell 17% on Thursday, there was little for traders to do but hope and pray. Instead, the European bourses have circuit breakers for individual shares, generally halting automated trading in those stocks for a few minutes after a sharp fall while an auction is held.
In fact, the London Stock Exchange (LSE) notched up an exceptionally high number of these trading halts—dubbed “price monitoring extensions”—in last week’s rollercoaster which saw the benchmark FTSE 100 fall by 7.6% on Monday, and then by 10.9% on Thursday.
There were more trading halts on FTSE 100 companies in the first four days of last week—154—than in the whole of 2019 when 119 were recorded, according to LSE data shared with Fortune.
You’d have to go all the way back to 2016, in the aftermath of Britain’s shock vote to leave the European Union, to witness the level of suspensions that were called on Monday, a market source said.
It was also a very busy week for the Frankfurt Stock Exchange’s Xetra electronic trading system. It does not have market-wide circuit breakers, but uses what it calls “volatility interruptions” to declare a time out when there are wide swings in the price of an individual stock. During a volatility interruption, Xetra slows down trading by switching from continuous trading in a particular share to a two-minute auction.
In the first three trading hours last Monday, Xetra chalked up an unusually high 1,300 extended volatility interruptions on Xetra. To compare—even on the frantic trading day after the 2016 Brexit vote, it had 1,198 volatility interruptions for the whole day.
Circuit breakers have their pros and cons. Supporters say they stop panic, forcing investors to take a more considered view, and allow time for any mismatch between buy and sell orders to be sorted out.
They can also provide valuable breathing space to figure out what’s going on when there is a “flash crash” caused by a trader’s “fat finger” slip or high-frequency trading.
In one notorious case, the Dow Jones Industrial Average plunged by nearly 1,000 points on May 6, 2010, wiping $1 trillion off U.S. stocks, after a mutual fund sold $4.1 billion of EMini S&P 500 futures contracts via an automated execution algorithm in 20 minutes, causing a liquidity crisis in that market. That wasn’t enough to trigger circuit breakers in place at the time, which in those days required a 10% drop in the Dow.
Critics say it can fuel panic among investors if they are prevented from selling their shares at that moment, and that setting a percentage trigger can encourage nervous investors to dump their shares in a sliding market before the circuit breaker kicks in and stops them from selling for a while.
A source at one European stock market said circuit breakers focused on individual stocks had worked well, whereas market-wide suspensions could lead to greater uncertainty among market participants and further increase volatility.
In last week’s cases, the U.S. trading halts didn’t produce any miraculous recovery but may have slowed the slide—the S&P 500 lost 7.6% Monday and 9.5% Thursday on the days the circuit breakers went into effect.
The China experience
After a series of sharp sell-offs in the Chinese stock market in 2015, the Shanghai and Shenzhen stock exchanges introduced a circuit breaker early in January 2016. The mechanism suspended trade for 15 minutes when the market fell by 5%, and halted it for the day after a fall of 7%. But the mechanism was scrapped within days after trade was halted twice.
The experience reinforced the criticism by some market watchers that such mechanisms are actually counter-productive. “The circuit- breaker mechanism is an artificial interruption of the market correction and it may actually strengthen the impact of the correction.” Zhu Bin, analyst at Southwest Securities in Shanghai, told the Financial Times at the time.
U.S. circuit breakers
Circuit breakers were introduced in the U.S. after the Black Monday stock market crash of October 19, 1987 when the Dow fell by more than 22%, still the biggest one-day percentage drop on record.
Before this week, market-wide circuit breakers were only triggered once before, on October 27, 1997, when trading was halted first for a half-hour and later for the remainder of the day, with the Dow ending down 7.2%.
The rules, initially linked to points changes in the DJIA, have since been refined and now apply to percentage moves in the S&P 500.
A cross-market trading halt can be triggered at three circuit breaker thresholds—a 7%-fall in the S&P 500 compared with the previous day’s close (Level 1), a 13% decline (Level 2), and a 20% drop (Level 3).
A market decline that triggers a Level 1 or Level 2 circuit breaker before 3:25 p.m. will halt market-wide trading for 15 minutes, while a similar market decline “at or after” 3:25 p.m. will not halt market-wide trading. A market decline that triggers a Level 3 circuit breaker, at any time during the trading day, will cease market-wide trading for the remainder of the trading day.
Like the European exchanges, the U.S. also has limits on moves in individual stocks, introduced in response to the 2010 “flash crash.” The “Limit Up-Limit Down Mechanism,” approved by the Securities and Exchanges Commission in 2012, prevents trades in individual stocks from happening outside a specified price band. This price band is set at a percentage level above and below the average price of the stock over the previous five minutes of trading. If a stock’s price does not move back within the price band in 15 seconds, it mandates a five-minute trading pause.
The European experience
Euronext, which operates stock markets in Paris, Amsterdam, Brussels, Dublin, Lisbon and Oslo, uses a system of circuit breakers triggered by big price moves in individual shares. It generally calls a 3-minute trading halt if share prices move outside of a certain range.
“Euronext’s general philosophy is not to halt trading except in extreme circumstances. To achieve this, we do not rely on circuit-breakers alone, but on a full set of trading safeguards,” Euronext says on its website.
Other market protection mechanisms used by Euronext include the power to reject aberrant orders (that are unusually large in size or in units/price) before they enter the market and the ability to halt instruments subject to single orders that might disrupt the market.
The European Securities and Markets Authority published a study in January analyzing the market impact of circuit breakers. Using a unique database of circuit breakers triggered between April and December 2016 on a sample of 10,000 financial instruments traded on European Union exchanges, it concluded that price volatility was significantly lower after the circuit breaker was triggered, while bid-ask spreads widen and the price discovery process was not negatively affected.
More must-read stories from Fortune:
—Is this your first stock market crash? Some advice for young investors
—Here are two of the biggest losers from the Saudi Arabia oil price war
—Why investors suddenly turned on pot stocks
—Here are some of the most extreme ways companies are combating coronavirus
—Why it’s so hard to find the next Warby Parker
Subscribe to Fortune’s Bull Sheet for no-nonsense finance news and analysis daily.