Circuit Breakers and Market Runs
50 Pages Posted: 12 Jun 2012 Last revised: 21 Sep 2016
Date Written: August 22, 2016
Merely out of fear for future liquidity shocks, traders may run on financial markets. We show this coordination failure could be overcome by applying circuit breakers (which curb excessive trading). However, the common-practice circuit breakers fall short of their potential and could even damage welfare. Our analysis suggests a novel forward-looking circuit breaker which (i) becomes most restrictive precisely when the expected social loss related to inefficient upfront trading is largest, and (ii) is only implemented when it yields a welfare contribution. Bridging to practice, the calibration of this welfare-optimal circuit breaker among others reflects (the fear of future) funding liquidity constraints.
Keywords: liquidity crisis, market stability, trading halt, high frequency trading, flash crash
JEL Classification: D53, G01, G10, G18
Suggested Citation: Suggested Citation