Cass Questions Circuit Breakers in New Study

Co-authored by Dr Giovanni Cespa of Cass Business School and Thierry Foucault from HEC School of Management in Paris, 'Illiquidity Contagion and Market Crashes' says that existing circuit breakers will not prevent another rapid market crash due to correlative exigencies between asset classes.

Instead, the paper argues, 'liquidity breakers' are needed to mitigate wild swings in indices, operating in tandem with common price-based breakers that trigger a halt when specific limits are breached. The advent of high-frequency trading (HFT) has bolstered increasing interdependence of markets, the study says, introducing elements of instability where information about underlying assets is heavily dependent on that garnered by the price. This can lead to situations where markets can rapidly switch from low to high illiquidity and trigger events such as the Flash Crash.

"Markets can therefore hover in different liquidity states for the same set of underlying fundamentals. This means that for a given underlying, the market can be in a high or a low illiquidity regime," says Cespa. "In the former state, aggregate order realizations due to temporary price pressures trigger huge price adjustments. In the latter, the same realizations command milder price movements. Thus, the price impact of orders of a certain size is not univocally determined. Within this framework, a switch from the low to the high illiquidity equilibrium is what causes a flash crash."

Specific triggers are needed to halt trading when market depth reaches certain trigger points, creating a second set of circuit breakers alongside those related to price. Simple limit up-limit down breakers are not guaranteed to prevent crashes and market routs in the situations described, say the academics.

"It could be an effective way to block an illiquidity spiral at its inception and thereby help traders to re-coordinate on a regime with higher liquidity," Cespa continues.

Specific triggers are needed to halt trading when market depth and width reaches certain trigger points, creating a second set of circuit breakers alongside those related to price.

The Flash Crash of 6 May 2010 saw the Dow Jones Industrial Index fall by 1,000 points in a matter of minutes, only to recover most of its value rapidly. The scare was blamed on a mixture of correlative trading between e-mini futures in different markets, and a downward spiral among trading algorithms which withdrew from the market and deepened the illiquidity trough. The repercussions of the event have led to greatly enhanced scrutiny of algorithmic trading strategies and their effects on the market, further prompted by similar events in India and other geographies.