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Circuit Breakers and Market Runs

Sarah Draus and Mark van Achter ()
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Mark van Achter: Rotterdam School of Management

CSEF Working Papers from Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy

Abstract: This paper analyzes whether the application of a “circuit breaker” to a financial market (i.e. a mechanism that interrupts trading for a predetermined period when the price moves beyond a predetermined level) reaches its intended goals of increased market stability and overall welfare. Our framework of analysis is a model in which investors can trade at several dates and might face a liquidity shock forcing them to sell immediately when the shock occurs. This setting potentially induces a “market run” where investors commonly sell merely out of fear other investors are selling and not because they have current liquidity needs. We show that the introduction of a sufficiently tightly-set circuit breaker within this setting successfully prevents this market run from occurring. Even more so, it could induce the socially optimal state (in which trading only takes place when it is motivated by liquidity needs) to arise. However, this desirable equilibrium can only be reached under particular economic conditions. When these conditions are not met, installing a circuit breaker might even lower social welfare as compared to a setting without a circuit breaker as it impedes socially desirable trades and stimulates socially undesirable trades.

Keywords: liquidity crisis; market stability; trading halt; high frequency trading; flash crash (search for similar items in EconPapers)
JEL-codes: D53 G01 G10 G18 (search for similar items in EconPapers)
Date: 2012-05-04
New Economics Papers: this item is included in nep-mst
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