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Circuit Breakers and Market Runs

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.

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Paper provided by Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy in its series CSEF Working Papers with number 313.

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Date of creation: 04 May 2012
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Handle: RePEc:sef:csefwp:313
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  1. Greenwood, Robin, 2005. "Short- and long-term demand curves for stocks: theory and evidence on the dynamics of arbitrage," Journal of Financial Economics, Elsevier, vol. 75(3), pages 607-649, March.
  2. Markus K. Brunnermeier & Lasse Heje Pedersen, 2007. "Market liquidity and funding liquidity," LSE Research Online Documents on Economics 24478, London School of Economics and Political Science, LSE Library.
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  4. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
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  9. Lauterbach, Beni & Ben-Zion, Uri, 1993. " Stock Market Crashes and the Performance of Circuit Breakers: Empirical Evidence," Journal of Finance, American Finance Association, vol. 48(5), pages 1909-25, December.
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  11. Gerety, Mason S & Mulherin, J Harold, 1992. " Trading Halts and Market Activity: An Analysis of Volume at the Open and the Close," Journal of Finance, American Finance Association, vol. 47(5), pages 1765-84, December.
  12. Charles S. Morris, 1990. "Coordinating circuit breakers in stock and futures markets," Economic Review, Federal Reserve Bank of Kansas City, issue Mar, pages 35-48.
  13. Lasse Heje Pederson & Markus K Brunnermeier, 2007. "Market Liquidity and Funding Liquidity," FMG Discussion Papers dp580, Financial Markets Group.
  14. James T. Moser, 1990. "Circuit breakers," Economic Perspectives, Federal Reserve Bank of Chicago, issue Sep, pages 2-13.
  15. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1343-66, September.
  16. Subrahmanyam, Avanidhar, 1994. " Circuit Breakers and Market Volatility: A Theoretical Perspective," Journal of Finance, American Finance Association, vol. 49(1), pages 237-54, March.
  17. Hendershott, Terrence & Jones, Charles M. & Menkveld, Albert J., 2008. "Does algorithmic trading improve liquidity?," CFS Working Paper Series 2008/41, Center for Financial Studies (CFS).
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  19. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports 328, Federal Reserve Bank of New York.
  20. Antonio E. Bernardo & Ivo Welch, 2004. "Liquidity and Financial Market Runs," The Quarterly Journal of Economics, MIT Press, vol. 119(1), pages 135-158, February.
  21. repec:dgr:uvatin:20110076 is not listed on IDEAS
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