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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. Markus K. Brunnermeier & Lasse Heje Pedersen, 2007. "Market Liquidity and Funding Liquidity," NBER Working Papers 12939, National Bureau of Economic Research, Inc.
  2. 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.
  3. Grossman, S.J. & Miller, M.H., 1988. "Liquidity And Market Structure," Papers 88, Princeton, Department of Economics - Financial Research Center.
  4. 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.
  5. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  6. Pierre-Olivier Weill & Johan Hombert & Bruno Biais, 2012. "Trading and liquidity with limited cognition," 2012 Meeting Papers 118, Society for Economic Dynamics.
  7. Subrahmanyam, Avanidhar, 1994. " Circuit Breakers and Market Volatility: A Theoretical Perspective," Journal of Finance, American Finance Association, vol. 49(1), pages 237-54, March.
  8. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports 328, Federal Reserve Bank of New York.
  9. Gromb, Denis & Vayanos, Dimitri, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 361-407.
  10. 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).
  11. Antonio Bernardo & Ivo Welch, 2006. "Liquidity and Financial Market Runs," Yale School of Management Working Papers ysm280, Yale School of Management, revised 01 Aug 2003.
  12. 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.
  13. William G. Christie & Shane A. Corwin & Jeffrey H. Harris, 2002. "Nasdaq Trading Halts: The Impact of Market Mechanisms on Prices, Trading Activity, and Execution Costs," Journal of Finance, American Finance Association, vol. 57(3), pages 1443-1478, 06.
  14. James T. Moser, 1990. "Circuit breakers," Economic Perspectives, Federal Reserve Bank of Chicago, issue Sep, pages 2-13.
  15. Allaudeen Hameed & Wenjin Kang & S. Viswanathan, 2010. "Stock Market Declines and Liquidity," Journal of Finance, American Finance Association, vol. 65(1), pages 257-293, 02.
  16. 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.
  17. Robert J. Shiller, 1987. "Investor Behavior in the October 1987 Stock Market Crash: Survey Evidence," NBER Working Papers 2446, National Bureau of Economic Research, Inc.
  18. Subrahmanyam, Avanidhar, 1995. "On rules versus discretion in procedures to halt trade," Journal of Economics and Business, Elsevier, vol. 47(1), pages 1-16, February.
  19. repec:dgr:uvatin:20110076 is not listed on IDEAS
  20. 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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