Circuit Breakers, Illiquidity, and the COVID-19 Crisis

Abstract

While designed to curb extraordinary volatility, I find that circuit breakers lead to unnecessary trading halts, especially during the COVID-19 crisis. Although created to accommodate the release of fundamental information to the market, most halts turn out to be illiquidity events. Halts further harm liquidity and impede short-term price efficiency. The channels through which liquidity gets depleted during the crisis include dark trading activity and the use of Intermarket Sweep Orders (ISOs). Also, halts in the S&P500 constituents are associated with jumps in SPY (an ETF that tracks the S&P500), a finding that has further implications for risk management. I conclude by providing guidance on how to refine the existing market mechanism to improve market quality and better deal with rare events.

Keywords: Circuit breakers, trading halts, volatility, liquidity, jumps, dark pools, ISOs, big data, market mechanism design, COVID-19, policy and regulation

JEL Classification: C14, C22, G12, G14