The use of circuit breakers significantly widens spreads immediately after the mechanisms are triggered, according to a study from the European Securities and Markets Authority (ESMA).
Analysing a database of circuit breakers triggered between April and December 2016 on a sample of 10,000 instruments traded on European venues, ESMA’s study investigated the impact of them as a tool for managing extreme price swings.
It found that while circuit breakers cause a decline in price volatility without negatively impacting the price discovery process, relative bid-ask spreads widen dramatically in the immediate post-circuit breaker trading phase.
“Over the period of analysis circuit breaker activation generally had a negative effect on liquidity (in terms of increase of the bid-ask spread) of both halted stocks and the cross-listed ones in the ten-minute following the circuit breaker trigger event,” the study said. “Calmer trading conditions come at the cost of higher spreads; the relative bid-ask spreads significantly increase after the halt, and the increase is even more pronounced for stocks cross-listed compared to the halted instruments.”
ESMA added that better understanding of circuit breakers across the industry is needed to understand the interactions between the mechanism and major market events, as well as flash crashes, the regulatory landscape and potential feedback loops between different mechanisms.
“While the new regulatory framework provides greater market transparency and promote orderly markets and financial stability, structural market developments as well as critical market incidences, such as flash crashes, will need to be analysed and fully understood to ensure a robust market functioning going forward,” the study concluded.