Trading and Exchanges Chapter 28: Circuit Breakers and Market Safeguards (Part 2)
In Part 1 we looked at how bubbles form and crashes happen. Now the obvious follow-up: can we actually prevent this stuff? Or at least make it less painful? Harris walks through the tools markets use to deal with extreme volatility, and the picture is more complicated than you would expect.
Trading Halts and Price Limits
The two main circuit breaker types are trading halts (shut down the market temporarily) and price limits (cap how far a price can move in one day). Both have supporters and critics.
The case in favor: when prices are falling fast, a trading halt gives everyone time to breathe. Informed traders who were not paying attention can step in and provide liquidity. Panicking uninformed traders get cut off before they do more damage. And standing limit orders get protected because trading resumes with a single-price auction where everyone gets the same price. This means people are more willing to leave limit orders in the book if they know a halt will protect them from getting steamrolled.
The Arguments Against
Opponents say circuit breakers can actually make things worse. The first reason is the gravitational effect. If traders know there is a halt threshold, they fear the market will hit it before they get their orders in, so they rush to trade sooner. This accelerates the very crash the circuit breaker was supposed to prevent. The limit acts like a magnet pulling prices toward it.
Second, if value traders know the media will alert them when a halt happens, they stop watching the market so closely. Less monitoring means less liquidity. The safety net makes the market lazier.
Third, the coordination problem. When one exchange halts but related markets stay open, order flow just moves somewhere else. If the stock exchange halts but futures does not, everyone piles into futures. Harris is clear: if you want circuit breakers, exchanges must coordinate them.
The Margin Collection Trick
One underappreciated benefit of price limits: they help brokers collect margin. If a position crashes 25 points instantly, the trader knows they are bankrupt and has zero incentive to pay up. But if price limits restrict the drop to 5 points per day, the trader might not realize how bad it will get. They post additional margin hoping for a rebound. By the time they figure out they are toast, the broker has already collected more money. Sounds cynical, but it protects the clearing system from cascading failures.
Transaction Taxes and Higher Margins
Some people argue that too much trading causes volatility, so just tax it or raise margins. Harris is skeptical. Yes, it would discourage gamblers and bluffers. But it would also hit dealers, value traders, and arbitrageurs, the exact people who keep markets liquid and prices accurate. A blanket tax cannot tell the difference between a gambler making bad bets and a value trader correcting mispricing.
Here is a subtle twist: removing uninformed traders might actually increase transitory volatility in the long run. Informed traders need uninformed traders to profit from. Without those profits, nobody does the research to identify correct values. The ecosystem depends on having all types of traders in it.
The Politics Behind the Rules
My favorite part of this chapter is Harris explaining why regulators behave the way they do. After the 1987 crash, regulators faced a game theory problem. If they do nothing and another crash happens, they get blamed. If they do nothing and no crash happens, nobody thanks them. If they adopt circuit breakers, they are covered either way.
The rational move? Adopt something mild. Which is exactly what happened. NYSE Rule 80B originally only triggered at a 12% drop, something that had occurred exactly once in history. Almost meaningless by design.
Then there is Rule 80A, which restricted index arbitrage. Harris argues this was less about stability and more about politics. Specialists on the NYSE floor outnumbered arbitrageurs massively (470 specialists versus about 20 program trading firms). Specialists competed with arbitrageurs for liquidity profits. Restricting arbitrage directly benefited specialists. They used the post-crash moment to push through a rule serving their own interests. Classic regulatory capture.
What Harris Got Right
Reading this chapter in hindsight is fascinating because Harris basically predicted how things went. He argued for coordinated circuit breakers across markets. After the 2010 Flash Crash, regulators implemented exactly that with market-wide breakers and individual stock limit-up/limit-down rules. He argued that discretionary halts have less gravitational effect than automatic ones. Modern exchanges now use a combination of both.
His broader point holds up too. The best way to prevent bubbles is not circuit breakers. It is making sure value traders have access to good information and can short sell freely. Circuit breakers are band-aids. Informed, empowered traders are the real immune system of the market.
Previous: Chapter 28: Bubbles and Crashes (Part 1)