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Sorry if this is a silly question.

It is my understanding that modern exchanges have "circuit breakers" which halt trading for a duration of minutes when there is significant volatility / price movements. So why do we still witness flash crashes such as the famous May 6 2010.

I'm not asking what causes flash crashes. I'm asking why circuit breakers don't prevent them.

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    $\begingroup$ @AlexC fair enough. Let's limit the question to cash equity markets only then $\endgroup$ – Kian Oct 16 '16 at 13:44
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As a preamble.

There are two types of "circuit breakers"

  1. if the price goes outside a (long term or static) corridor defined as yesterday close +/-p% (very often p is a multiple of the long term volatility): "stop the market" and "reopen";
  2. if the price goes outside a (short term or dynamic) corridor defined as previous trade price +/-q%: "stop the market" and "reopen".

Then you can "stop" and "reopen" different ways:

  • Stop can be from really reject / cancel any order to accept orders only in one direction
  • Reopen is often implementing a fixing auction after at least M minutes.

You will find more information in this consultation paper for Olso Exchange.

Moreover, there is not a concensus among exchanges to know if the rules (and especially p and q) should be publicly disclosed or not. For instance Germany is in favour of secrecy where France is not.

To answer directly to your question:

Yes: circuit breakers prevent "flash crashes" every day (see for instance High Frequency Trading and Mini Flash Crashes, by Anton Golub, John Keane, Ser-Huang Poon). Nevertheless you can see a flash crash before the activation of the circuit breaker. The question is then "should the market have been closed sooner?". In my opinion it is a never ending story: you can stop markets very often and "avoid" too large flash crashes, or you can accept wider variations of prices but have a more consistent liquidity across the market. Remember the issues of having several components of an index suspended, but ETFs "pegged on it" open to trade... (have a look at US EQUITY MARKET STRUCTURE: LESSONS FROM AUGUST 24, by blackrock).

The point is to have enough liquidity providers to prevent most flash crashes, but you will never demand to a liquidity provider to "catch a falling knife"... It is the role of the exhanges (with the support of regulators) to find ways and mechanisms so that specialists (not in the old sense but in a new one, to be defined) provide enough liquidity to prevent "stupid" flash crashes.

The last one on the Sterling was probably not a "stupid" one: as a liquidity provider, it seems natural (and a good risk management practice) to stop providing liquidity in the turmoil of the Brexit when the Sterling is going down...

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