The horse hasn’t bolted, yet!

The Flash Crash catapulted circuit breakers into the public spotlight and showed how they (or rather the lack of them) can impact financial markets. Since then, in Europe at least, discussions have been relatively quiet. European markets are perhaps less prone than others to such massive price swings for two reasons. Firstly, Europe does not have the trade-through rule and, secondly, single instrument-based circuit breakers are already widely implemented here.

Though judging by ESMA’s busy work schedule, the European regulator is reviewing the existing circuit breaker regimes, and with good reason. European market structure has changed fundamentally within the last few years so, like MiFID and MAD, it’s time for a review. Maybe we can secure the stable door before the horse has bolted.

Since 2007 markets have become more fragmented and integrated at the same time. Today, Vodafone can be traded on more than 15 different venues. In parallel, a new breed of HFTs has emerged that ensures that prices in all venues trading Vodafone are the same. So, even if trading is fragmented across many markets, investors can be quite sure that they will get a roughly similar price on all venues. Keeping that in mind, the question arises whether all of those venues should harmonise their circuit breaker regimes. On the one hand, harmonising circuit breakers could reduce loopholes for market abuse and regulatory arbitrage, while on the other hand, harmonising them creates monocropping of safeguard measures. This may not be the best way to secure a resilient market.

In the derivatives markets today it is quite easy to trade equity risk without actually investing in anything that is counted in shares. It may be CFDs, options, futures – or any combination of the above – that creates the risk exposure an investor is seeking. Thus, price discovery may not necessarily stem from the underlying but from linked derivatives markets via arbitrage. Therefore, in some cases the derivatives markets are determining prices and the equity markets follow. Regulators might want to consider whether circuit breaker regimes should be more aligned and harmonised across asset classes as well. However, prices for options behave much more erratically due to the nature of their payoff structure. Standard price thresholds may, therefore, be anything but practical!

Closely related to derivatives is the issue around indices. It might be easy to link the Vodafone CFD or option to the underlying, but what happens to trading in options of the iShares EURO STOXX 50® ETF when 15 constituents of the STOXX 50® have triggered their circuit breakers at the same time? How do circuit breaker regimes impact the calculation of indices, and do those rules need to be harmonised too? The massive increase in passive investment via indices makes this point especially relevant and, since Porsche squeezed the market for VW shares, we all know that one single constituent can bias the long-term performance of any index.

There are numerous tell-tale signs that suggest a review of the European circuit breaker regime is due, but this whole area is far from simple and ESMA is not to be envied the task of making so many difficult decisions! Yes, the horse shouldn’t bolt, but locking the stable door and throwing away the key is not the solution.

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