Circuit Breakers, Illiquidity, and the COVID-19 Crisis

Abstract

I identify the economic triggers behind the recently introduced stock-level circuit breakers and evaluate their market impact during the COVID-19 crisis. Although designed to halt trading in volatile markets caused by informational shocks, these circuit breakers are often triggered by short-term liquidity shocks instead. This results in halts that are followed by reduced liquidity across all securities and worse price discovery in smaller securities. The liquidity depletion in lit markets is driven, to some extent, by increased dark pool trading in larger securities and the widespread use of Intermarket Sweep Orders (ISOs) in smaller ones, revealing market fragmentation. Additionally, circuit breakers inadvertently facilitate the transmission of toxic equity volatility to the derivatives market. To mitigate these unintended consequences, I propose refinements to the existing mechanism to minimize the impact of trading halts and improve the management of rare events like the COVID-19 crisis.

Keywords: Circuit breakers, volatility and liquidity, jumps, market fragmentation, ETFs, policy and regulation, big data

JEL Classification: C14, C22, G12, G14