At the time of the 1987 market crash, attention was directed to the issue of the relationship between cash and derivative markets. On the one hand, it was argued by some that the disconnection between the two markets at critical times resulted in free­falls in the two markets, and that the lack of policy measures for coordination between the two markets accelerated the price declines in both markets.

On the other hand, it was argued by others that the speed of the market declines was unaffected by the lack of such policy measures and that trading in the futures markets actually stabilized the cash markets.

Notwithstanding the divergence of views, the experience of the 1987 market crash has highlighted that the cash and the derivative markets should be considered as "one market" economically, and focused regulators' attention on the proper role for coordination of supervision of the cash and the derivative markets. Specifically, attention has been focused on the development of measures to minimize market disruption. In addressing this issue, this paper focuses on circuit breakers, price limits and the need for open and timely communication among relevant regulators and markets.

In this paper, market disruption can be defined as the effects of large, rapid market declines that threaten to create panic conditions, or disorderly market conditions, [see Brady Report (January 1988), Interim Report of the Working Group on Financial Markets (May 1988) and OECD Report ("Systematic Risks in Securities Markets", February 1991)].

Current Measures to Minimize Market Disruption

Circuit Breakers

Circuit breakers are essentially a trading halt in the cash market, and a corresponding trading halt in the derivative markets triggered by the halt in the cash market, all of which are effected based on substantial movements in a broad market indicator. Following the October 1987 market crash, a system of coordinated trading halts and reopenings was instituted in the U.S. All of the stock and futures exchanges have adopted these circuit breakers in order to deal with large, rapid market declines which could potentially create panic conditions. Three other jurisdictions which have implemented circuit breakers are France, Switzerland and Quebec, Canada.

It has been argued that circuit breakers have the following advantages:

° They provide a "time out" to calm down frenetic trading and also to assess market participants' financial capacity; and

° They facilitate price discovery by providing a "time out" to pause, evaluate and publicize order imbalances to attract counter orders working as a cushion against excessive volatility in the market.

On the other hand, it has been argued that circuit breakers have the following disadvantages:

° They affect investors' trading strategies for risk management;

° They deprive investors of transaction opportunities, thereby shutting the exit from the market;

° They have some adverse impact on price discovery;

° They increase the divergence between stock prices and stock index futures prices; and

° They drive concerned investors to alternative markets that do not implement circuit breakers or alternative instruments.

Shock Absorbers

In the U.S., securities markets also have implemented intermediate measures, or so called "speed bumps" or "shock absorbers", to slow securities trading when markets experience significant volatility. The New York Stock Exchange's ("NYSE") Rule 80A provides that when the Dow Jones Industrial Average Index ("DJIA") moves up (down) 50 points or more, all index arbitrage orders to buy (sell) component stocks in the S&P 500 index on the NYSE may only be executed on a minus (plus) or zero­minus (zero­plus) tick (Up­tick and Down­tick rule).

Several U.S. futures exchanges also have adopted "shock absorbers" or "speed bumps" which are also intended to slow down, but not to halt, stock index futures trading. These less restrictive trading rules consist of temporary and maximum daily price limits on the price movements at levels much narrower than circuit breaker levels. These include opening price limits for stock index futures traded at the Chicago Mercantile Exchange ("CME") or the New York Futures Exchange ("NYFE") which are set at the equivalent of 40 DJIA points and which are effectively in place only for the first ten minutes of trading; interim price decline limits set at 100 DJIA points for stock index futures traded at the CME, Chicago Board of Trade ("CBT") and the NYFE; and maximum daily price limits of 160 DJIA equivalent points for stock index futures traded at the CME, CBT, and Kansas City Board of Trade.

Price Limits

In Japan, special quotes and daily price limits are implemented in cash and derivative markets. The quote is used when there is a major order imbalance. And a special quote, keeping orders unmatched temporarily, is publicly disseminated to enable market participants to respond to order imbalances, and to prevent drastic price volatility. The price limit prevents excessive daily swings in prices by setting acceptable daily price ranges. Coordination of trading halts in cash markets and derivative markets can also be made flexibly in Japan since both markets share information very frequently and are under the administration of one regulatory body.

In France, daily price limits are also implemented in cash and derivative markets. Securities traded on the French markets are divided into three categories according to the number and volume of daily transactions and price limits vary according to the category to which the security belongs. For instance, for the more liquid category, when the price movement of a security exceeds 10% from the quoted price at the close of the previous market day, quotation is suspended for 15 minutes. After 15 minutes, transactions begin again. If the price then goes up or down by more than 5%, transactions are again suspended for 15 minutes. The 5% threshold may apply once more before transactions are halted for the rest of the day. When transactions are suspended in the cash market on a given security, due to undue price movement, transactions on the option based on the underlying security are also suspended. Further, when more than 35% of the capitalization of the CAC­40 Index is unable to be quoted, the calculation of the CAC­40 Index is suspended and the index is replaced by a trend indicator. When less than 25% of the capitalization of the CAC­40 Index is able to be quoted, quotations on the derivative markets are suspended for half an hour or one hour when additional margin deposits are requested. Other jurisdictions, such as Germany and Italy, also implement price limits (in the case of Germany only in the cash market).

Not all markets use circuit breakers or price limits to address large, rapid declines. At least one jurisdiction, the U.K., operates neither circuit breakers nor price limits because they believe that market makers adequately adjust stock prices at the time of market disruption and therefore that a "time­out" is not necessary. In the U.K., the exchange may determine that a market movement is so sharp that quotes cannot practically be kept current; under its Fast Market Rule it may permit market makers to trade outside quoted ranges where updating quotes is deemed impractical.

Open and Timely Communication

Regulators recognize the importance of information sharing as a means of facilitating regulatory decision making during periods of large, rapid price declines. Such communications and related arrangements increase visibility to regulators of firms most at risk due to market events, highlight possible clearing and settlement problems and increase information flows regarding payment system demands. These arrangements also facilitate surveillance of derivative and cash markets and facilitate decision processes concerning what measures to take. In particular, increased communication and access to relevant information can assist in ensuring that regulatory responses do not exacerbate the situation because they are based on inadequate information.

Coordination Between Cash and Derivative Markets

The foregoing differences in approaches to circuit breakers and price limits demonstrate that, in establishing such measures, regulatory authorities and markets should take into consideration their unique market circumstances, mechanisms of trading, and legal and market customs and practices. However, with the rapid growth of derivative markets in recent years, and the concomitant arbitrage with cash markets, it is difficult in some cases to prevent market disruption through regulatory measures in only the cash or derivative market.

Therefore, regulatory authorities should keep pursuing desirable, coordinated measures between the cash and the derivative markets to minimize the effects of potential market disruption based on recognition that cash and derivative markets are one market from an economic point of view. When pursuing such measures, it is important for regulatory authorities and markets to review experiences of other jurisdictions which already have coordination measures in place between cash and derivative markets.

International Coordination

In recent years, with the liberalization and internationalization of capital markets and liberalization of capital mobilization, the world's stock markets have become increasingly linked through the cross-listing of stocks and the development of derivative products based on foreign stock markets. It can be said that the world's stock markets have become increasingly interdependent with each other.

When considering measures to minimize disruptions, regulatory authorities and markets should be mindful of the interdependence of the world's securities markets.

Therefore, regulatory authorities and markets should make efforts to achieve international consultation and coordination of policy measures in anticipation of occasional large, rapid price movements. Specifically, the market trading derivative products based on foreign cash markets, should coordinate, to the extent possible (consistent with the public interest, such as the protection of investors and the maintenance of fair and orderly markets) with the measures taken by the underlying stock markets so as not to reduce the effect of the measures, and vice versa.

Proposal for Future Work

Regulatory authorities and markets should make substantial efforts to maintain and enhance lines of communication among themselves, both at the domestic and international levels, in order to minimize the effects of potential market disruption. To that end, it would be valuable for regulatory authorities and markets to enhance mechanisms for facilitating open and timely communication among themselves. The Working Party proposes to consider and seek agreement on principles applicable to such mechanisms and to consider such principles and related issues. This Working Party will take into account and not duplicate the work done by the Working Party on Exchange of Information and Enforcement.

Off­exchange trading is a concern in some jurisdictions, since it may not be subject to the same regulatory regime as exchange trading. This matter is not addressed in this paper and may require further study.