TESTIMONY OF ARTHUR LEVITT, CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING CIRCUIT BREAKERS BEFORE THE SUBCOMMITTEE ON SECURITIES OF THE SENATE COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS JANUARY 29, 1998 Chairman Gramm, Senator Dodd, and Members of the Subcommittee: Thank you for the opportunity to discuss circuit breakers today. We appreciate the keen interest that Congress takes in our nation's capital markets, which are indisputably the best in the world. We at the Commission work every day to protect the integrity of those markets and investors in those markets. One of the most important features of U.S. financial markets is that they function efficiently and freely, even in times of extreme stress. A decade ago, the securities and futures markets, in response to the most severe market drop in the history of our financial markets, introduced circuit breakers -- coordinated, cross-market trading halts intended to give investors and the markets a "breather" during the maelstrom of a steep market drop.<(1)> Circuit breakers were intended to help avoid panic <(1)> Attached as Appendix A is a summary of the significant measures that can be taken to protect the markets in the event of severe declines. The Commission has authority to take a variety of measures in response to (continued...) ======END OF PAGE 1====== and systemic breakdown, but only when the stress of a truly severe market drop prevented the financial markets from operating in a fair, orderly and efficient manner. The Commission believes that markets function best when they are unencumbered by artificial constraints like circuit breakers. The strength of a free market is the underpinning of our financial system and, in fact, our economy. Simply put, markets operate best when they are open. That is not to say that there can be no justification for circuit breakers. On those rare, very rare, occasions when there may be systemic overload, it may be necessary to provide a short pause for participants to reassess market conditions. The circuit breakers have been triggered once -- during the market events of October 27, 1997. The drop that day, however, did not represent the type of extraordinary decline that circuit breakers were meant to brake. When the circuit breakers were triggered, the markets were working efficiently, and there was no threat of an imminent market breakdown. Shortly thereafter, representatives of the securities and futures markets, the Commodity Futures Trading Commission ("CFTC") and the Commission met to discuss experiences with the triggering of circuit breakers on October 27. A quick consensus was reached to raise the levels at which the circuit breakers are triggered to better reflect a severe market decline, given the increase in market levels since 1988. Commission staff also coordinated <(1)>(...continued) extreme market volatility and other emergency circumstances. ======END OF PAGE 2====== several meetings and telephone calls with the self-regulatory organizations ("SROs") and the CFTC to discuss additional modifications to the circuit breaker rules. Today's hearing is timely because the New York Stock Exchange ("NYSE") is about to bring to its Board significant proposed changes to the operation of its current circuit breaker rules. The Commission recognizes that the NYSE, as well as the other securities and futures SROs, need to take swift, coordinated action to ensure that circuit breaker rules more effectively serve their purpose -- to give investors and the markets an opportunity to regroup when the markets experience rapid declines. I. Overview Consistent with our commitment to free and open financial markets, the Commission resists any effort to impede the markets' efficient operation. The Commission prefers that the securities markets operate without unnecessary restraints. For this reason, the Commission believes that mechanisms like circuit breakers, that impede the natural functioning of markets, should only be imposed in the most extreme circumstances. For circuit breakers to be of any value, they should be used only on those rare occasions when the market decline is of historic proportions and, as a result, the markets and supporting technology are headed for disarray. -- Circuit breakers should be triggered only in extraordinary circumstances. Circuit breakers were meant, from their inception, to be triggered only in truly extraordinary circumstances -- i.e., a severe ======END OF PAGE 3====== market decline when the prices have dropped so dramatically that liquidity and credit dry up, and when prices threaten to cascade in a panic-driven spiral. As long as the markets are closed or have the potential to close early, there is uncertainty. Uncertainty for individual investors leads to confusion. They cannot rely on the market being open until 4:00 p.m. in deciding when to place their orders on a day when the market is falling. Uncertainty for mutual funds, which cannot calculate daily net asset value without a market from which to price, is also of concern. The absence of net asset values also could undermine general investor confidence in our nation's financial markets. This underscores the importance of thinking very hard before concluding that markets should close early for the day. -- The current circuit breaker trigger points should be raised. There is general consensus that the current levels for the circuit breakers should be raised. Without such a change, circuit breakers threaten to interfere with the exceptional resilience of the U.S. financial markets. The Commission is very interested in proposals to change the limits from a fixed point amount to a point amount based upon a percentage drop in the Dow Jones Industrial Average ("DJIA")<(2)> and to reevaluate these limits periodically. The exchanges currently are discussing whether to raise circuit breaker triggers to 10 percent for the first halt and 20 <(2)> "Dow Jones Industrial Average" is a service mark of Dow Jones & Company, Inc. These percentages would be converted at the end of each year into point totals based on market closing prices over a fixed period. ======END OF PAGE 4====== percent for the second halt. If circuit breakers had been in place at these levels since 1915 (when the DJIA was created), they would have been triggered by only two market events -- the "crash" of October 1929 and the "break" of October 1987 (as shown in the bar graph at Appendix B).<(3)> These two occurrences involved the type of truly extraordinary circumstances that were meant to trigger circuit breakers. -- The markets should have an orderly close every day. Our nation's financial markets have on many occasions reaffirmed their preeminence by weathering, among other things, wars, natural disasters, and severe market drops, without closing. With this in mind, we are discussing with the markets and the CFTC if and how to resume trading after the triggering of a 20 percent circuit breaker. The Commission would prefer some attempt to reopen markets closed by circuit breakers, even if the circuit breakers are triggered late in the trading day. Individual investors have come to rely on the markets being open until 4:00 p.m., and make their investment decisions on that basis. If an early close prevents investors from making their trades, they may begin to lose confidence in the U.S. markets. It appears, however, that the securities, options and futures exchanges believe that after a drop of 20 percent, reopening in an orderly fashion would be difficult. This point is still under discussion and should be resolved shortly. On the other hand, if a 10 percent circuit breaker were triggered, the Commission would expect the markets to reopen in an orderly <(3)> Although the graph at Appendix B shows three separate days on which the circuit breakers would have been triggered, the crash of 1929 occurred over two days, October 28 and October 29, 1929. ======END OF PAGE 5====== manner and, if possible, to resume trading until the regular end of the trading day, when closing prices could be established. -- The international financial markets look to the U.S. financial markets. The world today looks to our nation's financial markets for leadership. Closing these markets at any time, even for a limited period, risks creating an unfounded impression that the U.S. financial markets cannot function. For this reason, it is that much more important that circuit breakers, which are designed to provide only a "pause" in trading, be triggered only in extraordinary circumstances. -- Advances in technology will require us to revisit periodically the circuit breaker rules. Technological advances enable our nation's financial markets to handle record volume trading days -- a billion shares have traded hands over the NYSE in one day without a glitch. Technological advances also assist in the wide dissemination of market information, so more investors can make informed decisions. Technological advances are changing the financial markets. The financial markets cannot reap the rewards of these technological advances and be held back by static circuit breaker rules, however. Thus, the Commission will continue to encourage the exchanges to revisit periodically their circuit breaker rules and to make the changes necessary to keep our nation's capital markets the most efficient, most liquid, and most diverse in the world. II. Background ======END OF PAGE 6====== Circuit breakers were developed by the securities and stock index futures markets in response to recommendations made by the President's Working Group on Financial Markets ("Working Group") to address the market break of October 1987, when the DJIA lost 508 points (almost 23 percent of its value).<(4)> Securities, options and futures exchanges adopted the Working Group's recommendation and created circuit breaker programs. The Commission initially approved the programs of the securities exchanges on a pilot basis in 1988.<(5)> <(4)> The Working Group is comprised of representatives from the Commission, the CFTC, the Treasury and the Federal Reserve Board. In 1988, the Working Group recommended coordinated trading halts and reopenings during large, rapid market declines. This group suggested specific circuit breaker trigger levels of approximately 12 percent and 20 percent of the DJIA, and recommended quarterly review of the levels to determine if they needed to be altered to reflect changes in the DJIA. See Working Group on Financial Markets, Interim Report of the Working Group on Financial Markets, May 16, 1988, at Appendix A. After the October 1987 market break, President Reagan appointed a task force to review the events of the market break. The task force recommended the implementation of circuit breakers to coordinate the reactions of the stock, futures, and options markets during times of market stress. See Presidential Task Force on Market Mechanisms, Report of the Presidential Task Force on Market Mechanisms, Jan. 1988, at 66 ("Brady Report"). Like the Commission and the Working Group, the task force concluded that coherent, coordinated circuit breaker mechanisms were preferable to "circuit breakers of chaos and system failure." Brady Report at 66. <(5)> The original pilot programs have been renewed and modified a number of times since 1988. See Exchange Act Release No. 26198 (Oct. 19, 1988), 53 Fed. Reg. 41637 (Oct. 24, 1988); Exchange Act Release No. 37457 (July 19, 1996), 61 Fed. Reg. 39176 (July 26, 1996); Exchange Act Release No. 38221 (Jan. 31, 1997), 62 Fed. Reg. 5871 (Feb. 7, 1997). (continued...) ======END OF PAGE 7====== In approving the circuit breaker pilot, the Commission hoped that the existence of circuit breakers would provide the markets with a chance to "pause" during a severe decline along the lines of October 1987, affording market participants and regulators time to assess market conditions and potential systemic stress.<(6)> At that time, then-Commission Chairman David Ruder testified that circuit breakers were a way to "calm the fear and panic that occurs when there are steep declines in the stock markets."<(7)> The Commission believed that the purpose of the circuit breakers was not to prevent the markets from adjusting prices. Rather, it was to restore an equilibrium between buyers and sellers, to provide the opportunity for increased information flow, and to create a <(5)>(...continued) The options, futures and other securities exchanges have adopted rules that are consistent with the circuit breaker rules of the NYSE. The National Association of Securities Dealers ("NASD") will halt trading on the Nasdaq Stock Market and trading in the over-the-counter market when the circuit breakers are triggered. Thus, when the NYSE circuit breakers are triggered, all the domestic financial markets effectively are closed. <(6)> Exchange Act Release No. 26198 (Oct. 19, 1988), 53 Fed. Reg. 41637 (Oct. 24, 1988); Testimony of David S. Ruder, Chairman, U.S. Securities and Exchange Commission, Concerning the Working Group on Financial Markets, Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce (May 19, 1988). <(7)> Statement of David S. Ruder, Chairman, U.S. Securities and Exchange Commission, Concerning the Working Group on Financial Markets, Before the Senate Comm. on Banking, Housing, and Urban Affairs (May 24, 1988). ======END OF PAGE 8====== better opportunity for market participants to assess information during times of extreme market movements.<(8)> On October 19, 1988, the DJIA was at 2137. Under the pilot programs approved at that time, a circuit breaker would have halted trading for one hour when the DJIA dropped 250 points (approximately 12 percent) from the previous day s close. Trading would have stopped for two hours when the DJIA reached 400 points (approximately 19 percent) below the previous day s close. These were extremely steep declines, based on the DJIA at that time. Since then, however, the dramatic rise in the DJIA has created the possibility that existing circuit breakers will trigger during less than extraordinary market declines. For this reason, in 1995 and 1996, the Commission and its staff urged the SROs to raise these levels as quickly as possible.<(9)> The SROs agreed to increase the triggers for the <(8)> Exchange Act Release No. 26198 (Oct. 19, 1988), 53 Fed. Reg. 41637 (Oct. 24, 1988); see also Statement of David S. Ruder, Chairman, U.S. Securities and Exchange Commission, Concerning the Working Group on Financial Markets, Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce (May 19, 1988). <(9)> See Exchange Act Release No. 38221 (Jan. 31, 1997), 62 Fed. Reg. 5871 (Feb. 7, 1997); Exchange Act Release No. 37890 (Oct. 29, 1996), 61 Fed. Reg. 56983 (Nov. 5, 1996); see also, Greg Ip, "The 1987 Market Peak and Crash; Ten Years After: Safeguards Make Crisis Less Likely," Wall St. J., Aug. 25, 1997, at C1; Patrick McGeehan, "Big Board Plan: No Shut Down Until 350 Points," Wall St. J., Dec. 6, 1996, at C1; Patrick McGeehan, "SEC, Big Board Reconsider `Circuit Breakers' That Almost Shut Down Trading Last Friday," Wall St. J., Mar. 15, 1996, at C1. ======END OF PAGE 9====== circuit breakers from 250 points to 350 points and from 400 points to 550 points, representing a 5.4 percent and 8.5 percent decline, respectively, in the DJIA at that time. The Commission approved these new triggers because they were a 40 percent increase over the outdated 1988 triggers, but they remain significantly lower on a percentage basis than the circuit breakers approved in 1988.<(10)> Circuit breakers were triggered for the first time on October 27, 1997. The first halt came at 2:36 p.m. and the second halt came at 3:30 p.m., closing the markets for the day. In total, however, the markets fell only a little more than 7 percent that day. There was general agreement that such a drop did not represent the type of extraordinary decline that circuit breakers were meant to brake.<(11)> III. Circuit Breaker Trigger Levels <(10)> Exchange Act Release No. 38221 (Jan. 31, 1997), 62 Fed. Reg. 5871 (Feb. 7, 1997). The Commission also stated that, while the new triggers were more appropriate, the exchanges should continue to monitor and reevaluate the criteria for determining when a market event was severe enough to warrant a circuit breaker. <(11)> Since October 27, 1997, a debate has emerged as to whether the circuit breakers acted as a magnet drawing the markets down toward the second trigger and therefore toward the closing of the markets for the day, or whether they acted as a stabilizing force in preventing a true market meltdown. See, e.g., Greg Ip and Michael Schroeder, "Trade Halt Questioned by Levitt: First-Ever Use Cited By Some for Turmoil," Wall St. J., Oct. 30, 1997, at C1; Greg Ip, "Bloody Monday: Stocks Plummet 7% as Pros Seek Cover to Protect 1997 Gains," Wall St. J., Oct. 28, 1997, at A1. ======END OF PAGE 10====== The market experience on October 27, 1997 has reinforced concerns that the present circuit breaker triggers are much too low as a result of the exceptional increase in market levels since 1988.<(12)> The Commission as a general matter does not favor market closings. The Commission has always believed that as long as the markets are functioning efficiently, they should remain open.<(13)> Unfortunately, however, the circuit breakers in place today will trigger on days with less than extraordinary trading, when markets are actually functioning efficiently, such as October 27, 1997.<(14)> Hence, many of the SROs are considering readjusting circuit breaker triggers to reflect a 10 percent and 20 percent fall of the DJIA, similar to the circuit breakers originally approved in 1988. <(12)> As previously noted, when established, the 250 point circuit breakers would be triggered by a 12 percent drop in the DJIA. By July 1996, a 250 point drop in the DJIA was only a 4.5 percent fall. By January 1997, 250 points was 3.7 percent of the DJIA. <(13)> See, e.g., Greg Ip and Michael Schroeder, "Trade Halt Questioned by Levitt: First-Ever Use Cited by Some for Turmoil," Wall St. J., Oct. 30, 1997, at C1; Statement of David S. Ruder, Chairman, U.S. Securities and Exchange Commission, Concerning Responses to the October Market Break, Before the House Comm. on Agriculture (June 14, 1988); Statement of David S. Ruder, Chairman, U.S. Securities and Exchange Commission, Concerning the Working Group on Financial Markets, Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce (May 19, 1988). <(14)> The Commission staff currently is reviewing the events of October 27, 1997. The staff will consider, among other things, the trading halts that occurred when the circuit breakers were triggered. Because this review has not been completed, we cannot report to you at this time on the staff's findings. ======END OF PAGE 11====== Why move to circuit breaker triggers of 10 and 20 percent? First, a move to a percentage-based calculation allows circuit breaker triggers to be reset each year to correspond with changes in the markets. In addition, 10 and 20 percent movements on a single day in a financial market of any size are very rare and dramatic. This corresponds to our view that circuit breakers should be triggered only in extraordinary circumstances. The Commission believes that, even if adjusted, the circuit breaker triggers should be reevaluated periodically. As described earlier, the securities, options and futures markets are very different from those existing in 1987. For instance, on the day after the October 1987 market break, 608 million shares traded hands on the NYSE. That volume, a record at that point, stretched the capacity of information, trading and settlement systems. In contrast, on the day following the October 27, 1997 market decline, the volume on the NYSE had doubled from October 1987, to 1.2 billion shares, and the systems were not even close to being stretched, because of the existence of technology and technological capacity undreamt of in 1987. In the future, economic developments, as well as new technologies, are certain to evolve that will permit the markets to grow and absorb even higher levels of activity. For these reasons, it is important to reevaluate circuit breakers, their operation, and their trigger levels periodically to ensure that they are triggered only when necessary. The Commission appreciates the recent efforts of the securities, options and futures markets to reach consensus on circuit breaker trigger ======END OF PAGE 12====== levels. We understand that next week the NYSE Board will consider fundamental changes to the NYSE circuit breaker rules to reflect a move to percentage-based circuit breakers.<(15)> If, however, at its February 5 meeting, the NYSE Board does not approve substantial increases in trigger levels, the Commission will consult with the CFTC to determine if regulatory measures are needed to raise circuit breaker trigger levels to resemble their original design.<(16)> IV. The Final Hour of Trading <(15)> Although the NYSE Board is expected to act on February 5, 1998 to approve readjustment of circuit breakers, these changes will have to be coordinated with other securities and futures markets. Given the publication, comment and approval requirements, coordination in this effort will be paramount. Because the current circuit breaker rules expire on January 31, 1998, earlier this week the Commission approved an extension for those rules until the sooner of April 30, 1998 or Commission and CFTC approval of new triggers. During this extension, minor adjustments will be made to prevent an unnecessary market closing due to relatively low circuit breaker triggers. Specifically, if the 350-point trigger is hit on or after 3:00 p.m., it is not implemented and the markets continue trading. If the 550-point trigger is hit between 2:00 p.m. and 2:59 p.m., it will last only 30 minutes, rather than 60 minutes. <(16)> In addition to cross-market trading halt circuit breakers, several other initiatives were developed since 1988 to address significant market movements, including the 50-point program trading collars imposed by the NYSE under its Rule 80A, as summarized in Appendix A. The Commission believes that these initiatives also are ripe for review, and has discussed them in meetings with the SROs and the CFTC. ======END OF PAGE 13====== The application of circuit breakers during the last hour of the trading day raises several issues -- (1) should circuit breakers ever be triggered during the last hour of trading? (2) should the markets reopen if circuit breakers are triggered during the last hour of trading, and if so, is there a minimum time needed for markets to be open before closing for the day? (3) could the markets reopen in an orderly fashion after a drop of 20 percent? Since 1934, Congress has charged the Commission with the responsibility to promote the operation of fair and orderly markets. Those who favor suspending circuit breakers during the last hour of trading argue that an orderly close to the trading day is essential to allow completion of routine market activities in a fair way. For example, if circuit breakers close the markets before 4:00 p.m., participants in the options and futures markets may be left without the ability to complete certain transactions and strategies, leaving them vulnerable to significant losses.<(17)> On the other hand, the use of circuit breakers towards the end of a day with a significant drop could serve to stop the markets from spiralling out of control as they move towards 4:00 p.m. Both sides argue in favor of fair and orderly markets. <(17)> For instance, market participants may be unable to unwind arbitrage positions. While their futures or options position may have expired, the early closing due to circuit breakers could preclude the unwinding of the stock leg of a position. This could be particularly troublesome on an expiration Friday. ======END OF PAGE 14====== Individual investors have come to rely on the markets being open until 4:00 p.m., and make their investment decisions on that basis. When an early close prevents investors from making their trades, resulting in investment decisions becoming colored by uncertainty, there is likely to follow erosion of investor confidence in the markets. Another concern is the uncertainty created for mutual funds in the event of an early close due to a triggered circuit breaker. Mutual funds cannot calculate daily net asset value without a market close from which to price. The absence of net asset values for mutual funds also could undermine general investor confidence in the financial markets.<(18)> This underscores the importance of thinking very hard before concluding that markets should close early for the day. If there is a day when the 20 percent circuit breaker is triggered, financial markets will be experiencing a drop of historic proportion. The Commission recognizes that it may be difficult, if not impossible, to reopen the markets late in the day after a decline of 20 percent. Moreover, if a drop of 20 percent occurred, significant credit concerns could arise that would thwart the possibility of an orderly reopening. On the other hand, the longer the financial markets are closed, the greater the possibility that reopening will be difficult. <(18)> See Letter from Matthew P. Fink, Pres., Investment Co. Inst., to Arthur Levitt, Chairman, Securities and Exchange Commission, Jan. 27, 1998 ("[C]losing the markets early could be harmful to the over 60 million mutual fund shareholders who have come to expect that the markets will close at 4:00 p.m., and that orders placed up until that time will get that day's net asset value."). ======END OF PAGE 15====== These are all important concerns. The exact details of early closings are being discussed by the SROs and CFTC and Commission staff at this time. V. International Financial Markets Look to U.S. Markets The world's financial markets look to the United States for leadership that comes from the strength of our nation's markets. Consequently, decisions concerning U.S. markets are not made in a vacuum. One of our markets' greatest strengths is that they operate unencumbered by artificial constraints -- they are free markets. Therefore, it is important to keep in mind how the world's financial markets will react if and when circuit breakers are triggered. A mechanism intended to avoid panic and systemic breakdown cannot be allowed to create the mistaken impression that the U.S. financial markets no longer can function effectively. It is extremely important, therefore, that circuit breaker rules be revised in such a way that any closing of U.S. financial markets is limited to the period necessary for regulators and market participants to assess market position and systemic stress. This will reassure global markets that the U.S. financial markets remain strong. ======END OF PAGE 16====== VI. Advances in Technology The premier status of our nation's financial markets today has been made possible in part by advances in market technology over the past ten years. This technology is another reason that circuit breakers must be adjusted. The markets ten years ago could not absorb half of the volume routinely handled by the markets today; the ability to clear and settle trades has become sophisticated in ways unimaginable ten years ago. Although circuit breaker triggers may move to 10 and 20 percent, future technologies are likely to further enhance the capacities of the financial markets. This may permit these markets to perform in an orderly fashion, with even greater volume and speed, and may at some point permit circuit breaker triggers to be set even higher. Technology enables the financial markets to process record numbers of transactions, to access massive amounts of information and to develop investment strategies that cross exchange boundaries. Technology also is making the financial markets more global. With this progress, circuit breakers, and other rules governing the markets, should continue to serve their intended purposes, and not "throw sand in the gears" of otherwise efficiently functioning markets. VII. Conclusion As the markets continue to grow and change, the regulatory community must regularly review the protective measures that can be imposed when faced with potentially destabilizing market events. Any mechanism ======END OF PAGE 17====== available must be scrutinized to determine whether it will achieve its intended goal with minimal market disruption. The Commission believes that the current initiatives to modify the circuit breaker rules are an essential part of this process, and looks forward to working with you, our fellow regulators and representatives of the financial markets to produce the most effective, least intrusive, circuit breaker programs possible. ======END OF PAGE 18======