It's easy to see how "circuit breakers" benefit Wall Street insiders. But it's hard to see how they benefit the rest of us. Maybe that's because they don't.
98/02-Good for Them
By Jim Rogers
Officials of the major stock exchanges and the federal government have recently been giving a lot of thought to what size handcuffs you and I should wear. They don't actually call them handcuffs. That's my word. They call them circuit breakers. Circuit breakers were invented by a group called the Brady Commission following the 1987 market crash. The first time one got used was last October 27, when a swoon in Asian markets caused the Dow Jones Industrial Average to plunge 554.26 points, or 7.2 percent.
Actually, two circuit breakers tripped that day. The first one tripped at 2:35 p.m., after the DJIA fell 350 points. It automatically suspended all trading for half an hour. The second one tripped at 3:30, when the market decline passed 550 points. The 550-point trigger was designed to close the market for one hour. But because there was just half an hour left in the session when it tripped, it ended up closing the markets for the rest of the day.
Not everyone was pleased with the circuit breaker's inaugural performance. Critics immediately emerged from the mahogany woodwork to say that the day's decline was too modest to merit closing the exchange. They noted that the Dow was much lower when the trigger points were established; they should have been adjusted to a much higher level.
The second halt in trading was especially aggravating to the many investors who depend on being able to trade stock at the market close to square their positions. Some unhappy folks also contended that the mere existence of the second circuit breaker virtually guaranteed that buyers would stay out of the market once the first one had gone off. After all, who'd be dim-witted enough to buy stock they could be forced to hold-no matter what-only moments later?
In response to this criticism, officials representing both the exchanges and the federal government met to discuss what adjustments might be made. Committees were formed, meetings were held, and votes were taken. In December, the New York Stock Exchange announced that its board had decided to adopt a number of tweaks to these supposed market safeguards. The exchange also promised to continue studying the issue in the hope that, as The Wall Street Journal reported in December, "more-sweeping changes" could be made in early 1998.
I suppose that all of this fanfare was intended to reassure investors, but it certainly didn't reassure me. Why? Because as far as I am concerned, the only sensible change that the exchanges could make would be to rip the plug out of the wall. This won't happen, of course, because circuit breakers are too important to the big shots who wield most of the clout on Wall Street. But at least little guys like me and you deserve to know the truth.
Back when it was formed, the Brady Commission was stocked with government regulators, exchange officials, and representatives from academia. Then as now, there was precious little information about the actual effect of trading halts on modern markets. The few studies that exist on the topic are sketchy and vague at best. That, however, didn't stop the Brady bunch.
At the time, I thought it was significant that no representatives from the commodities markets were invited to serve on the Brady Commission. You'd think that would be the natural thing to do, since no one has more experience dealing with wild markets. But perhaps the people who did the inviting already knew that every professional commodities trader on the face of the earth regards circuit breakers as an idiotic idea.
I wasn't at the meetings, but I'd guess that, in confronting the "threat" of a fast-moving, out-of-control market, the government and academic members of the commission had a natural human impulse: We need some brakes. To these folks, the idea of circuit breakers seemed like common sense.
The stock-market representatives on the commission, however, had a different agenda. They were interested in protecting their pocketbooks. Basically, the big Wall Street firms wanted to be sure that in the event of a severe market drop they'd get paid even if their customers went broke. They realized that a cooling-off period would give brokers time to call clients with margin accounts in order to ascertain who should be forced to sell (because they were out of money to cover their positions). Without such a halt, the big firms might get stuck having to cover their customers' losses themselves, since the firms are ultimately responsible for settling up on all trades that they execute. (Note that no one has ever suggested, at least to my knowledge, putting brakes on a market that rises too fast.)
On October 27, Wall Street's insiders discovered another thing they like about trading halts: Insiders are the only ones during these time-outs who have a clue as to what's going on.
As long as markets are open, you and I have an instant source of information that allows us to gauge the prevailing mood as well as the current assessment of what each of our holdings is worth. The quoted prices tell us everything we need to know. When the market is closed, however, we're in the dark.
Not so for the big firms. The phones buzz as brokers and traders try to find out what everyone is thinking and what their customers intend to do next. The insiders might learn, for instance, that I want to sell my IBM holdings at $100 a share-and that there are a lot of other investors who would like to do the same. The insiders might also discover that very few prospective buyers want to pay that much. Thus, the insiders know that when the market reopens the price of IBM stock is going to be closer to, say, $85 a share than $100. You and I don't have a clue that this is going on.
So what do the insiders do with this information? With the market set to re-open, brokers put together a sell order for all folks they've rounded up who want to get out of IBM as soon as possible, along with those who are being forced to sell IBM because their margin accounts are tapped out. All of these go into a basket that will get dumped on the market as soon as it re-opens.
Once trading resumes, the market becomes keenly aware of an imbalance of sell orders for IBM. But only the insiders know how deep the carnage will be, how far the stock is likely to fall-and therefore the exact point at which they can safely begin to buy.
Given the advantages of circuit breakers to member firms, I don't have much hope that the exchanges will come to their senses and realize that a market isn't a market unless it's open. I do think, however, that they will end up losing business as a result of this shortsightedness.
To whom? To independent firms like Jefferies & Company and Cantor Fitzgerald, which have created a venue for the public to trade between the time the New York markets close and the opening bell the next day. There's nothing illegal about this; you and I may meet anytime and anyplace to buy or sell our stocks. Investors trade U.S. stocks offshore all day every day on the markets in Europe and Asia. Trades also occur on the Internet and on Instinet.
The NYSE seems to forget that during World War I (when it shut down for four and a half months after its governors decided that it was "unseemly" to trade stocks with the country at war) brokers took to the streets in lower Manhattan and traded stocks on the curb. Thus was the "curb market" born-a market that eventually grew into the American Stock Exchange.
Senior contributing editor Jim Rogers is an international investor. |
