The new circuit breaker system designed to avoid a repeat of 2010's flash crash will fail to avert another market meltdown unless it is coupled with 'liquidity safety valves', warns a new piece of academic research.
Responding to the May 2010 flash crash, which sent the S&P 500 index plummeting in minutes, the SEC initially introduced circuit breakers which pause trading in stocks if their prices change by more than 10% in five minutes.
Next year these will be replaced with a 'limit up-limit down' mechanism, where trades in listed stocks will have to be executed within a range tied to recent prices for that security.
But researchers from London's Cass Business School and the HEC School of Management in Paris argue that the limit up-limit down system will not be enough to prevent another rout because the advent of high frequency trading has led to markets becoming progressively intertwined.
Co-author Giovanni Cespa says: "This liquidity evaporation may materialise in one market first, triggering a spiral that drags all assets into the illiquid regime. Price based circuit breakers do not necessarily offer a good protection against such illiquidity spirals because the latter may happen without trades and therefore without changes in prices."
To counter this risk, Cespa and co-author Thierry Foucault call for new 'illiquidity-based circuit breakers' in tandem with price-based ones. This would mean trading could be stopped when market-wide depth falls below a specified threshold.
"It could be an effective way to block an illiquidity spiral at its inception and thereby help traders to re-coordinate on a regime with higher liquidity," adds Cespa.