A sudden drop in the S&P 500 Index this morning at the market open triggered a "circuit breaker" across the major stock trading exchanges, and as a result, trading in all stocks and ETFs was automatically paused for 15 minutes.
On the surface, any pause in normal market activity can be worrying for investors. However, trading halts exist as a safety mechanism, to discourage investors from panic selling and to preserve orderly price discovery.
In fact, though marketwide halts are uncommon, they do happen. The last time an exchangewide trading halt occurred was in December 2008, amid the global financial crisis.
However, trading halts in individual securities can and do occur all the time, when their prices exhibit enough volatility either up or down.
Understanding Circuit Breakers
There are three levels of circuit breakers for the stock markets, which are consistent across the three major exchanges:
When the S&P 500 index sees a 7% drop from the previous day's price, it trips a "Level 1" circuit breaker, halting trading activity for 15 minutes. (That's what happened Monday morning.)
If the S&P 500 continues to decrease, falling to a 13% drop from the previous day's price, then a "Level 2" circuit breaker trips, halting activity for another 15 minutes. This will only happen if the drop occurs on or before 3:25 p.m. Eastern time, so as not to coincide with end-of-day trading.
Note: The 7% circuit breaker can't be tripped more than once in a trading day; meaning, if the S&P 500's price rises above a 7% decline, then again falls past 7%, it won't trip the Level 1 breaker again.
If the S&P 500 hits a 20% decrease from the previous day's price, then a "Level 3" circuit breaker will automatically cease all trading activity for the rest of the day. (Unlike the Level 2 circuit breaker, this threshold can trigger at any time of day.)
Market circuit breakers have existed for some time. However, the current thresholds were established in 2013, after the previous version had failed to prevent the 2010 flash crash, and have never before today been triggered during normal market hours.
Biggest Worry: What Happens Afterward?
After a trading halt occurs, the biggest worry is what happens after it lifts. Once the 15 minutes are up, will market activity resume as usual, or will prices go haywire?
That's especially a concern for ETFs, which source their net asset values (NAVs) based on the prices of their underlying holdings.
If a trading halt makes it impossible to source accurate, up-to-the-second prices for an ETF's underlying stocks, then the authorized participants in charge of creating and redeeming shares of the ETF will no longer be able to confidently price the fund itself, potentially leading to bad prices and wider trading spreads on reopen.
That's what happened during the "flash crash" of 2015. Consequently, the three major exchanges agreed to implement uniform rules governing when their circuit breakers would trip and how auctions would reopen when they did.
Next Circuit Breaker Unlikely To Trip
As a result, today there have been isolated reports of bad pricing in a few ETFs, but on the whole, auctions appeared to resume as normal following the 15-minute halt.
"Talking to market makers, seems like ETF spreads a touch wider in some places but nothing crazy, all things considered," wrote Eric Balchunas, Bloomberg's senior ETF analyst.
After the trading halt lifted at 9:49 a.m. Eastern, the S&P 500 Index had rebounded somewhat. As of this writing, the benchmark currently is hovering around a 5.5% decline, and it does not seem poised to strike the Level 2 circuit breaker of 13%.
"U.S. equity market mechanics related to the market-wide circuit breakers and Limit Up/Limit Down in ETFs worked well and as designed during today's volatility," said Laura Morrison, senior V.P. and global head of listings for Cboe Global Markets (which owns ETF.com).
That said, anything can happen in volatile markets. We will continue to update this story as the day progresses.
Contact Lara Crigger at [email protected]