TESTIMONY OF
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 collars.

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 Executive Order.⁽¹⁾

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 Index.

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 specific markets.

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 accommodated.

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 the public.

Proposed Amendments to Circuit-Breaker Rules by the New York Stock Exchange

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.

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).