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Circuit breakers are an effective tool for managing volatility, according to a new document – Circuit breakers and market quality – from the World Federation of Exchanges (WFE).
The paper, which is its second on the subject, found that on average, stock returns stabilize, selling pressure subsides and prices become more informative after trading resumes after trading halted at the market scale.
The paper also demonstrated that traders tend to refrain from aggressive trading just before trading stops, which is inconsistent with panic-inducing circuit breakers, the so-called magnet effect. .
While not new, these events have been in the spotlight since March 2020, when Covid 19-induced volatility triggered market-wide circuit breakers four times.
WFE Research used a sample of stocks around the S&P500 index threshold to analyze how measures of market quality, including stock returns, volatility, spread-based measures, order imbalance and measures of market microstructure, move around market-wide trading stops.
By comparing these metrics before and after market-wide circuit breakers (MWCBs), the report showed that, in general, market conditions improve significantly after trading ceases.
In examining the changing market conditions leading to MWCBs, there was inconsistent evidence of the presence of magnet effects.
WFE Research also compared the effects on companies in the S&P500 with those outside the S&P500 and found no significant differences in the effects of MWCBs between stocks at the bottom of the S&P500 index and those just outside. of the market index, suggesting that index membership or index funds have no additional impact on market quality during MWCBs.
Furthermore, comparing the effects of MWCBs with single-action circuit breakers, the report noted that liquidity providers tend to become more reluctant to provide liquidity after MWCBs than after the single-action shutdown.
“In our circuit breaker study published last year, WFE Research described the various safeguard mechanisms used by exchanges to ensure market quality,” said Dr. Pedro Gurrola-Perez, head of WFE Research and the one of the authors of the article.
He added: “In this new research paper, we now investigate their impact from a market microstructure perspective. As stock exchanges around the world calibrate their safeguard mechanisms to the characteristics of their markets, our results contribute to our overall understanding of these mechanisms by providing empirical evidence of their effectiveness in the case of US markets.
Nandini Sukumar, Managing Director of the WFE, said: “These results have important policy implications, as they indicate that the circuit breakers triggered in March 2020 have helped ease pressure on the financial market.
We find that circuit breakers in the United States are adequately designed and serve as an effective protection mechanism used by exchanges. Overall, the WFE research results indicate the effectiveness of circuit breakers as an effective protection mechanism used by exchanges.
This article first appeared in Best Execution, a publication of Markets Media Europe.