BROOKSLEY BORN, CHAIRPERSON
COMMODITY FUTURES TRADING COMMISSION
BEFORE THE U.S. SENATE
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
SUBCOMMITTEE ON SECURITIES
JANUARY 29, 1998
Mr. Chairman and Members of the Subcommittee:
I am pleased to appear on behalf of the Commodity Futures Trading
Commission ("Commission") today to discuss the
Commission's views concerning the issues raised in your letter of
January 16, 1998. In my testimony, I will address the operation of
circuit breakers on October 27, 1997, potential modifications to those
circuit breakers, and the Commission's views regarding the New
York Stock Exchange ("NYSE") index arbitrage trading
Origin of Circuit Breakers
The extraordinary volatility experienced in the financial markets on
October 19, 1987, led to the adoption of circuit breakers. On that
date, the Dow Jones Industrial Average ("Dow Index")
declined by 508 points, or 22.6 percent of its value. Shortly
thereafter, the President's Working Group on Financial Markets
("President's Working Group") was established by
The President's Working Group was charged with the responsibility of developing recommendations to reduce the possibility of serious market disruptions or systemic failures as a result of future significant market declines. After extensive analysis and factfinding, the President's Working Group submitted a report to the President.(2)
In the Report, the President's Working Group recommended, among
other things, the implementation of price limits and trading halts
coordinated across all financial markets, commonly referred to as
"circuit breakers." The President's Working Group also
recommended that the circuit breakers should be subject to frequent
review and modification.
Specifically, the President's Working Group recommended that all
U.S. markets listing equity and equity-related products halt trading
for a period of one hour whenever the Dow Index declined by 250
points, in 1988 a drop of approximately 12 percent, from the previous
day's closing level. The President's Working Group also
recommended a second trading halt for a two-hour period if the Dow
Index declined by more than 400 points, a drop of 20 percent, from the
previous day's closing level.
The President's Working Group recognized that trading halts should
occur only in rare and compelling circumstances -- situations
comparable to the October 1987 market break, which was characterized
by "systems breakdowns, reduced liquidity, and concerns over
trading because of fears of counter-party and even clearing
corporation failure."(3) In order
to insure that the circuit breakers did not disrupt markets during
periods of less market volatility, the President's Working Group
suggested that the circuit breakers should be adjusted quarterly to
reflect 12 and 20 percent of the Dow Index.(4)
Effective October 20, 1988, the securities, option, and futures
exchanges instituted circuit-breaker rules that conformed to the
President's Working Group's recommendations. Over the last ten
years, only two significant changes to the circuit-breaker rules have
been implemented. Effective July 26, 1996, the exchanges adopted rules
shortening the trading halts associated with 250-point and 400-point
declines in the Dow Index to one-half hour and one hour, respectively.
Effective February 3, 1997, the exchanges adopted rules increasing the
circuit-breaker triggering levels to 350 and 550 points from 250 and
400 points, respectively. At that time, 350 points and 550 points
corresponded to approximately 5.2 percent and 8.1 percent of the Dow
Circuit-Breaker Implementation on October 27, 1997
On Monday, October 27, 1997, the circuit breakers were triggered for
the first time when the Dow Index declined by 350 points, or 4.5
percent, from its previous day's close. In accordance with the
circuit-breaker rules, trading was halted across securities, option,
and futures markets. The circuit breakers operated in the manner
intended, and trading halts went into effect with a significant degree
of coordination subject only to differences of a few minutes between
In discussing the events of October 27, 1997, I will focus upon the
NYSE, the largest securities market, and the Chicago Mercantile
Exchange's ("CME") S&P 500 futures contract, the
largest stock index futures market. The experiences of those markets
and the manner in which they coordinated with each other are fairly
representative of the markets.
The NYSE halted trading at 2:35 p.m., when the 350 point circuit
breaker was hit.(5) Trading in the
CME's S&P 500 futures contract was halted one minute later
when that market dropped 45 S&P 500 index points -- a level
corresponding to 350 points on the Dow Index.
After a one-half hour trading halt, the NYSE commenced reopening the
equity markets at 3:05 p.m. Trading in the CME S&P 500 futures
contract resumed at 3:07 p.m., two minutes after the NYSE reopening,
when as required by the circuit-breaker rules, 50 percent of the
individual stocks comprising the S&P 500 index, as measured on a
capitalization basis, were reopened on the NYSE.
At 3:24 p.m., 17 minutes after reopening, the CME S&P 500 futures
contract reached another price limit when it dropped 70 S&P 500
index points, the equivalent of 550 Dow Index points. As provided in
the circuit-breaker rules, the futures contract continued to be open
for trading at the limit price until 3:33 p.m. when it closed because
the NYSE halted trading as a result of the triggering of the second,
550-point Dow Index circuit breaker. Because the second trading halt
lasts for an hour and the NYSE ordinarily closes at 4:00 p.m., all
equity and equity-related markets remained closed for the remainder of
the trading day, and the Dow Index closed down 554 points, or 7.2
percent, from the previous day's close. Although this was the
largest numerical daily decline in the Dow Index in the history of the
NYSE, it was only the twelfth largest decline as a percentage of the
Dow Index level.
The operational and systemic improvements which the futures exchanges
had implemented since 1987 enabled them to handle the high volumes and
extraordinary cash flows of October 27, 1997, effectively. Orders were
filled, cleared, and margined without systemic problems. For example,
the CME successfully cleared a record $3.7 billion through its system
on October 27, 1997. Volume and transaction levels which substantially
exceeded levels for typical trading days were easily
Current Evaluation of Circuit Breakers
The market drop on October 27, 1997, presents the first opportunity to
evaluate how the circuit-breaker rules worked in practice. The
triggering of the circuit breakers has stimulated discussions among
regulators, exchanges, and market participants concerning the
appropriateness of the current rules. In particular, the discussions
have focused on whether the circuit-breaker levels should be adjusted
to reflect the significantly higher level of the Dow Index since their
initial implementation. As noted above, when originally implemented in
1988, the circuit-breaker trigger levels represented decreases of 12
percent and 20 percent in the Dow Index, rather than the much lower
levels of 4.5 percent and 7.2 percent at which the circuit breakers
were triggered on October 27, 1997.
As a result, there is an ongoing discussion about the role that
circuit breakers should play in the financial markets. In the course
of that discussion, certain issues need to be addressed in order to
determine the appropriate levels for circuit breakers. Fundamentally,
a determination must be made in the context of today's markets as
to what constitutes a level of price volatility warranting trading
halts. How much financial risk can markets and market participants
accept before there is a need to close markets? At what point should
the price discovery function of markets be limited to protect their
financial integrity? What is the appropriate duration of trading halts
such that their potential benefits can be realized without unnecessary
market disruption? Consideration also should be given to circumstances
under which it may be appropriate not to reopen markets once closed.
In particular, there are operational impediments to reopening both
equity and futures markets when trading is halted late in the trading
day. The exchanges are actively addressing these issues, and the
President's Working Group is also considering these matters and is
preparing a report that will be provided to Congress.
Circuit breakers may play a useful role in times of extreme price
volatility. Market participants may use the period of a temporary
trading halt to assess market information, price levels, and their own
situations. Exchanges may assess the financial status of their
clearing mechanisms and perform other surveillance responsibilities.
Brokerage firms may check the financial condition of their customers
and their own compliance with net capital and segregation rules. This
temporary suspension of trading activity also may calm market
participants and help prevent panic from occurring.
The Commission believes that the affected exchanges need to work
together in a coordinated manner concerning changes in their
circuit-breaker rules. The exchanges should agree on appropriate
increased levels for circuit breakers to be submitted for regulatory
review and should coordinate their rules and their implementation. Any
new circuit-breaker levels should take into account the improved
ability of exchanges to handle trade execution and clearing. In
addition, any changes should be implemented with adequate notice to
Proposed Amendments to Circuit-Breaker Rules by the New York Stock
The existing circuit-breaker rules of the NYSE were to expire on
January 31, 1998. On November 21, 1997, a meeting took place among SEC
and Commission staff and officials of the U.S. financial exchanges at
which there was an informal consensus among the exchanges for
increasing the circuit-breaker levels. On January 8, 1998, the NYSE
formally submitted to the SEC a request for an extension, until April
30, 1998, of the current circuit-breaker rules with only minor
modification. That modification relates to the manner in which trading
halts would occur beginning at 2:00 p.m. on a trading day. The NYSE
did not consult with the futures exchanges concerning this
modification prior to proposing it. The NYSE intends to implement this
modification effective February 2, 1998. In order to coordinate with
the NYSE, the futures exchanges have submitted to us comparable
proposed rule changes, which were approved on January 27, 1998.
As recently as this week, the exchanges reached a preliminary
consensus to increase the circuit-breaker levels to 10 percent and 20
percent of the Dow Index. The numerical circuit-breaker levels would
be revised to reflect such percentages of the Dow Index in January and
July of each year. The exchanges also have been discussing changes to
the timing and duration of the trading halts. The Commission
understands that the exchanges may seek to implement the additional
changes effective May 1, 1998, through formal rule submissions to
their respective regulator for approval.
The Commission will promptly assess any formal rule submissions
proposing changes to the circuit breakers by the futures exchanges.
The Commission also plans to continue its review of circuit-breaker
issues and to coordinate closely with other members of the
President's Working Group.
New York Stock Exchange Rule 80A Trading Collars
In 1988, the NYSE adopted index arbitrage trading collars in NYSE Rule
80A and implemented them in 1990.(6)
These collars limit the ability to execute index arbitrage trades on
the NYSE by imposing a market direction condition on each stock order
involved. The NYSE adopted this rule on the grounds that those trades
could exacerbate volatility. The collars' trigger level of 50
points constituted 2.5 percent of the Dow Index level in 1988 when
Rule 80A was adopted.
The President's Working Group's 1988 Report did not comment upon, or make any recommendations concerning, index arbitrage trading. The collars concept was developed unilaterally by the NYSE. The SEC's approval of the collar rule expressly contemplated that the NYSE would evaluate and adjust the 50-point trigger to reflect changes in the value of the Dow Index.(7)
Although the NYSE has amended Rule 80A on several occasions, it has
never adjusted the trigger level to reflect the significant rise in
the value of the Dow Index since 1988. As a consequence, the frequency
with which the collar has been triggered has increased dramatically,
as illustrated by the following table. As the table shows, for
example, trading collars were activated a total of 304 times during
1997 -- an average of more than once per trading day. During that
year, 50 points represented only a 0.60 percent to 0.79 percent move
in the Dow Index, less than one-third of the 2.5 percent it
represented when adopted.
|YEAR||TOTAL 80A ACTIVATIONS||UPSIDE COLLARS||DOWNSIDE COLLARS|
The Commission recommends that, at the least, the trigger level for NYSE Rule 80A should be increased substantially to reflect the increase in the Dow Index. The Commission is unaware of any evidence which demonstrates a current need for NYSE Rule 80A's artificial limitation on index arbitrage trading and believes it may tend to disconnect the securities and futures markets. Moreover, the very significant operational improvements that have been made by the NYSE enable it to handle much larger trading volumes with greater reliance upon its automated order routing and execution facilities than was the case in 1988. This should eliminate any concern regarding the impact of index arbitrage. The Commission is unaware of any other reasons to believe that index arbitrage trading currently has a material impact on NYSE volatility. Unless a need for NYSE Rule 80A can be demonstrated, the Commission recommends that its trading collars should be eliminated. We urge that the NYSE should address this matter promptly and in connection with its action on circuit breakers.
1. The President's Working Group is comprised of the Chairperson of the Commission, the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve System, and the Chairman of the Securities and Exchange Commission ("SEC").
2. Interim Report of the Working Group on Financial Markets, dated May 1988 (hereinafter "Report").
3. Report, page 5.
4. Report, Appendix A, page 3.
5. All references to time are Eastern Time.
6. As part of Rule 80A, the NYSE also implemented a "sidecar" provision in 1988. That provision diverts program trading orders in S&P 500 stocks routed through the NYSE's automated execution system into a separate execution file which is subject to a five-minute delay. This restriction applies whenever the CME's S&P 500 futures contract declines by 12 points, which is approximately 100 points in the Dow Index.
7. SEC Release No. 34-25599, File No. SR-NYSE-88-02 (April 19, 1988), 53 FR 13371 (April 22, 1988).