I’m puzzled. Earlier this year I was involved in a project examining natural gas price volatility, and as part of the background work I examined circuit breakers in futures contracts. As it turned out, the circuit breaker on the NYMEX natural gas futures contract was the most permissive by a wide margin.
Circuit breakers are market rules that trigger a temporary stop in trading when a price moves by more than a specified amount compared to the previous day’s close. In some cases, the circuit breaker simply prevents price movements beyond the limits without a stop in trading. For example:
- Price movements on frozen pork bellies at the Chicago Mercantile Exchange are limited to 3 cents per pound up or down from yesterday’s closing price.
- Prices movements on corn futures on the Chicago Board of Trade are limited to 20 cents per bushel up or down.
- Price movements on NYMEX copper futures of 20 cents per pound will trigger a 15-minute suspension of trading. Trading will resume with the circuit breaker expanded to 40 cents above or below the previous day’s closing price.
As of March 24, when I compiled the information, these price limits represented a little over 3 percent for frozen pork bellies, about 9.5 percent for corn futures, and under 14 percent for copper.
In contrast, it would take a price movement for NYMEX natural gas futures of $3 per mmBTU, or more than 40 percent of the price as of March 24, to trigger a 5-minute trading suspension. Trading resumes with a circuit breaker expanded to $6 per mmBTU; hitting that limit triggers another 5-minute trading suspension and another $3 expansion of the circuit breaker. There is no maximum trading limit during any trading day.
At the cost of a single five-minute stoppage in trading, prices would be permitted to swing as much as $6 per mmBTU above or below yesterday’s closing price. Today’s price is about $6.30 for June delivery, meaning after a single trade stoppage prices could range from $0.30 to $12.30.
This is my puzzle: Such a limit is hardly relevant to market activity, so why does NYMEX bother to have the limit at all?
The academic literature on circuit breakers focuses mostly on stock market trading, not commodities futures. Some articles suggest that circuit breakers could be destabilizing, because traders fearing a trade stoppage may rush to trade before the stoppage, a rush to trade that itself may bring about the price movement triggering the stoppage. One article worried that trading halts would interfere with the continuous trading that promotes efficient price discovery.
Other articles point out that a trade stoppage may allow markets and brokers time to issue margin calls, or otherwise adjust to unusual trade volumes or price changes. In addition, to the extent that price limits reduce price risk, lower margin requirements may be allowed.
An interesting paper by Kodres and O’Brien in the 1994 American Economic Review suggests that price movement limits may be efficiency enhancing for hedgers, but not for speculators. Such a differential impact may explain the popularity of circuit breakers on commodity markets.
However, all of these articles assume that the circuit breaker is at least potentially binding. For all practical purposes, the circuit breaker on NYMEX natural gas futures contract doesn’t bind. So why does the NYMEX have such a limit on natural gas futures contracts?