Doctoral Dissertation Research in DRMS: Financial Circuit Breakers: Theory and Experiments

University Of California-Santa Cruz, Santa Cruz CA

Investigators

Abstract

Although now widespread in financial markets, circuit breakers -- mandated halts in trading when prices fall very rapidly -- remain quite controversial among researchers. The research adapts recently developed techniques from the theory of financial market runs and from continuous time random processes, in order to build a theoretical model that clarifies the potential benefits of circuit breakers. The focus is on runs on a financial market induced by fear of liquidity shocks. Theoretically, a temporary trading halt may eliminate the inefficiency caused by early liquidations when fundamentals are good. A circuit breaker operates by providing agents with time to learn about the fundamentals, when private incentives to wait for better information are insufficient. The other proposed contribution, perhaps more important, is empirical. The laboratory experiments to be conducted will be informed by the new theoretical model. More specifically, the experiments will compare laboratory financial markets with and without circuit breakers in two different parametric settings: one where circuit breakers theoretically should succeed in restoring financial stability and another where circuit breakers are expected to fail. These predictions are drawn from a model based on rational agents. The current project will analyze whether they are robust to the actual behavior of human subjects. The broader impact includes the ongoing policy debate on the regulation of financial markets. Circuit breakers are now widespread, but are not yet supported by a scientific consensus. Using the tools of game theory and experimental economics to redesign circuit breakers can lead to important welfare gains, especially in this time of financial instability. The study will highlight the key determinants of the effectiveness of circuit breakers, such as the quality of the information available to the market participants and the investors' psychology.