Trading halts and risk management: a new approach needed

Times have changed since trading halts came into existence after the 1987 crash. Today’s portfolio managers need new systems, order types and innovations to provide more options to execute complex risk-management strategies in periods of heightened volatility and trading halts.

More harm than good?

In March, market-wide circuit breakers were triggered four times on news of the pandemic, and traders are expecting more of the same uncertainty going forward. Circuit breakers can be helpful, but at times the risks associated with the unintended consequences of trading halts need to be managed.

Circuit breakers give traders time to digest information, but they may also lead to a disruption in the price discovery process. Trading halts may even cause panic-selling to worsen as investors rush to get their trades in ahead of the next expected trading halt. Complex risk-management strategies can also be stifled during periods of repeated market-wide trading halts.

Circuit breakers may also have the perverse effect of raising price variability. China’s experience with circuit breakers serves as an extreme example of how the unintended consequences of trading halts could create significant risk-management challenges for traders, portfolio managers, and other market participants.

When circuit breakers must be halted

In January 2015, the China Securities Regulatory Commission (CSRC) put a market-wide circuit breaker in place to halt trading for 15 minutes if the market fell by 5%, and then for the day after a 7% decline. Unfortunately, the trading halt did not help to stem losses: investors triggered the circuit breakers repeatedly, causing the CSRC to flip-flop on the use of market-wide circuit breakers. Soon, almost half of China’s firms had halted trading.

By mid-2015, China’s market fell 30% over three weeks, and the regulator was forced to shut down the circuit-breaker mechanism entirely, after it appeared that market halts were causing the selling frenzy to intensify. The CSRC continued its attempts to control the panic-selling by limiting short selling and giving cash to brokers to help them prop up the market. But after the trading-halt mechanism had been in place for only four days, the regulator officially suspended the circuit-breaker following intense criticism from investors. China’s trading-halt mechanism remains suspended to this day.

Crisis of confidence?

China’s experience with circuit breakers illustrates the negative unintended consequences that may result for investors that are not given enough execution options. In fact, for as long as circuit breakers have been in use, academics, exchange organizations and practitioners have been debating their effectiveness across a variety of market-quality benchmarks.

Repeated triggering of trading halts, one after another, may also lead to a crisis of confidence in financial markets. Each time the market halts and investors are denied access, doubt about the market’s ability to carry out its basic function – matching buyers and sellers – builds, and investors look to alternative trading venues and technologies to help execute their risk-management fiduciary responsibilities. Concerns about the level of transparency in securities prices may also build over time as the price discovery process is impeded by trading halts.

Toward a new solution

Risk-management strategies are designed to help minimize losses, in much the same way as circuit breakers. The difference is that circuit breakers are a ‘one size fits all’ approach, while modern risk-management techniques take a variety of forms tailored specifically to an investor’s own unique global, multi-asset, risk-management requirements.

Circuit breakers and trading halts serve their purpose, but global market structures and investment strategies have evolved significantly over the past 30 years. Now, more than ever, new solutions and trading technologies are needed to help portfolio managers manage risk through the type of unexpected ‘3-sigma events’ that have become increasingly common in recent years. Further research and development are needed to modernize trading systems, venues, order types and approaches that support a wider range of portfolio and risk-management trades through periods of heightened volatility and trading halts.

Further reading:

Future Chartis research on market structure will address the key technology trends that are of ongoing importance for buy-side investment managers. These include transaction cost analytics, execution algorithms, smart order routing, artificial intelligence and machine learning, order management systems, execution management systems, securities exchanges, alternative trading venues, bank capital and liquidity, and in-house vs. outsourced trading.

• Hedge Fund Risk Management Technology

(2018, Chartis)

• Trading Venues Face Resilience Test in Covid-19 Pandemic

(2020, WatersTechnology)