October 12, 2008
Circuit Breakers? Failed Regulation after the 1987 Crash
Posted by Mike Guttentag

In the last post, I described how portfolio insurance, the main culprit in the October, 1987 stock market crash, led to a cascade of selling and a precipitous drop in share prices.  In this post I review the regulatory response to the October, 1987 crash.  The most significant regulatory measure implemented in response to the 1987 stock market crash was the establishment of a system of market-wide “circuit breakers.”  Circuit breakers are mandatory, temporary halts in trading activity that are triggered if the market rises or falls a certain amount (initially the range was defined in terms of points and later adjusted to percentages).

The intuitive appeal of circuit breakers is obvious: markets appear to be moving “too fast,” and regulators need to do something to “slow them down.”  Equally predictable is the likely response of most economists: circuit breakers prevent markets from serving many useful purposes.  What is surprising is not that circuit breakers were an idea initially considered in response to the 1987 crash.  Rather, what is surprising is that circuit breakers were the one regulatory measure adopted after synthesizing the findings from six different private and public studies carried out in the months following the 1987 crash.

How could the culmination of six studies by well-regarded groups that certainly included at least some economists (reports were prepared by the Commodity Future Trading Commission, the Chicago Mercantile Exchange, the GAO, the New York Stock Exchange, the SEC, and one by a presidentially-appointed task force, the Brady Commission Report) yield circuit breakers as the best regulatory response?  If we hope to craft more effective regulatory responses this time around, it will be useful to understand why so many smart people backed circuit breakers after the 1987 market crash. 

There were several reasons for the attractiveness of circuit breakers as a regulatory remedy.  First, circuit breakers appeal to a common perception of how markets should work.  Prices should change in relatively small increments.  If stock prices drop dramatically, something must be wrong.  Either there is not enough liquidity (despite evidence of high trading volumes) or there is not enough rationality (despite innumerable sophisticated market players).  Implicit in the expectation that prices should change in a reasonably predictable manner is the assumption that the supply and demand curves for financial securities are similar to those describe in introductory economic textbooks, rather than similar to those revealed by the adoption of portfolio insurance strategies by institutional investors.   Without a sound theoretical understanding of what had occurred, circuit breakers seemed a reasonable palliative. 

Second, it is necessary to acknowledge the political reality of financial regulation in the United States.  Regulators do not want to be perceived as inattentive or inactive, but there is a general consensus that markets will resolve most problems through their own machinations.  Regulatory measures that balance some form of decisive action with a general deference to market mechanisms are appealing in the US.  (This is why disclosure regulation is always such an attractive regulatory solution here.  Disclosure requirements appear to provide neither too little nor too much intervention.)  The allure of circuit breakers is that they do not affect most day-to-day market activity, but they are there “just in case.”

A third reason for the adoption of circuit-breakers after the 1987 crash was the concern that the market-making mechanisms on Wall Street might not be capable of continuing to deal with high volumes and sudden price swings.  There is some evidence that the margin call system (which insures that investors using borrowed funds to purchase securities maintain adequate reserves) was overwhelmed in October, 1987.  Of course, a more logical approach to concerns about market-making capabilities would be to insure that sufficiently robust trading systems are in place.  Fortunately, exchanges have generally done a good job of staying ahead of increases in trading volume since then.

Finally, the focus on circuit breakers was the product of a process that I would describe as academic capture.  Around the time that the market crashed in 1987 there was a growing academic interest in how market liquidity can be maintained when there are significant information asymmetries.  For example, Sandy Grossman (I think still a colleague of Glomer Zaring at Wharton) was doing interesting work on the foundations of market liquidity.  The excitement generated by this line of academic research led those studying the crash to look at the crash through the lens of a “liquidity trap.”  No one seemed to notice that during the crash (and most other crashes) trading volume is phenomenally high.  (Perhaps to atone for this episode of academic capture, years later Grossman co-authored a paper that identified the potentially destabilizing effects of portfolio insurance, which I discussed in my previous post.)  Academics were curious about how markets remain liquid.  As a result, mechanisms to facilitate liquidity, such as a time-out to allow for the aggregation of supply and demand orders, inevitably became an area of regulatory inquiry.

Most economists would probably agree now that circuit breakers do not make sense.  Given the obvious political allure of circuit breakers, it is important that we deconstruct their appeal as a regulatory measure, so that we do not fall into the same post-October 1987 trap again.   

In the next post, I will consider what a reasonable regulator might have done in response to the October, 1987 crash.  Following that discussion, I will illustrate why all this talk of October 1987 is not just a cautionary tale about regulatory ineptness, but also is directly relevant to our current conundrum.

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