In response to the market collapse on the 24th of August 2015, the China Securities Regulatory Commission announced that circuit breakers would be introduced into the Shanghai and ShenZhen Stock Exchanges to halt trading if market index were to fall by specific proportions.
No one would have expected that just four months after the announcement, on seventh of January 2016, the circuit breaker was already triggered for the first time. The market fell by five percent triggering a circuit break after only thirteen minutes of trading. Investors were given fifteen minutes to regain composure, with the hope of even-headed trading. However, the goal of the break was not realised, as one minute into re-opening, investors raced to dispose of their shares so that they could escape the market. A further decline of two percentage points meant that markets were closed off for the rest of the day (“China’s Stockmarket Crashes – Again”, 2016).
The reasons for such a rush to dispose of shares are not clear-cut – theories of behavioural finance come into play; as well as the lack of trust by the average person for big Chinese investors who are thought to bend the rules for their own benefits, manipulating prices with a few backroom chats to qualify their actions. On top of that, the Chinese Market is not known for its transparency. Being skeptical of the introduction of circuit breakers, Chinese investors are likely to have over-reacted due to their mistrust in the regulators (Kim, 2016).
Nonetheless, this incident has inevitably shed light into the largely unexplored world of stock market circuit breakers.
WE NEED A BREAK
Markets are volatile and easily rattled, so it is important for regulators to balance the need to maintain integrity and confidence with the need for markets to operate free of undue interference. It was the first contemporary market crash of 19th October 1987 ‘Black Monday’ that spurred the invention of the circuit breaker. In the instance of a significant, sudden market decline, the circuit breaker would kick in to bar all trading in the specific market in an attempt to maintain liquidity and prevent panic-selling. The thought process behind this is to give the market time to breathe and process information so participants make informed rather than knee-jerk responses. Theoretically, this helps prevent further share plunges and unnecessary realised loss for investors stemming from panic sell-offs (Liu, 2016). Regulatory bodies and exchanges will also be granted additional time to provide market with information and fix any potential technical glitches (Liu, 2016)
The first enactment of a circuit breaker was in October 13th 1989 but full closure of market operations was not until October 27th 1997 when the DJIA declined 7.18% on the day. Before 1997, circuit breakers were meant to trigger when the market had declined by more than a pre-specified point as compared to the monthly average S&P 500 closing price. However, this particular trigger was deemed unnecessary by the market as the decline was not disastrous, thus in response, the system was reconfigured to include percentage drops as well as point drops.
Over the years, these specific ‘trigger’ points have been altered multiple times. They are usually threshold based and the process is conventionally administered at three stages. In the United States now, the limit for Level 1 is at a 7% decline, Level 2 is a further 6% fall and Level 3 is when it is at 80 cents on the dollar. Level 1 and 2 halt trading for 15 minutes prior to 3:25 pm, and Level 3 suspends trading for the remainder of the day.
‘Stock specific breakers’ were also introduced as a US response to flash crashes, and have occurred multiple times. They fall under the Limit Up – Limit Down rule which safeguards individual stocks by putting price bands around each stock price. If a stock price deviates a certain percentage away from the mean level of the last 5 minutes of trading, circuit breakers will shut the market down for 5 minutes.
A FLAWED DESIGN?
However, after years of implementation, there is evidence suggesting that the regulators’ signature trick could potentially be a double-edged sword.
On top of behavioural finance factors and the lack of trust for big-time investors, the inability to control volatility after the circuit break in January suggests that a circuit breaker may be interfering with the maintenance of market liquidity and the price discovery process, which are precisely the two main functions it is meant to perform. Particularly for institutional investors, the activation of a circuit breaker could potentially disrupt trading operations and settlements. This exposes firms to unnecessary risks as the temporarily closed market would leave unfinished transactions hanging mid-air, bringing a lot of uncertainties onto the table until trading resumes. Taking this to the extreme, this might also lead to a chain of defaults on firm obligations, such as debt repayment and acquisition funding, which would in turn spread the risks and cost to the rest of the economy (Liu, 2016).
In fear of liquidity shortage, traders may act in favour of their own self interest. When price movements are getting nearer to the limits, traders face the risk of being denied the opportunity to sell their position and exit the market on time. Being at the informed side of the deal, traders are able to better anticipate a circuit break and alter their strategies. By locking in their own sell orders quickly, and consequently putting more downward pressure on price, traders are able to completely leave the market before it hits rock bottom. This is known as the “magnet effect”. The very existence of a circuit breaker is likely to influence an investor’s decision when a price point is almost triggering the breaker (Subrahmanyam, 1994).
Additionally, coordination of circuit breakers is crucial in a fragmented investment environment. Without proper design, a circuit breaker could still fail to limit volatility. Subrahmanyam (2013) argues that the coupling of fragmented markets and inter-related assets will diminish the efficiency of these circuit breakers. For instance, if the stock market is shut-down, trade volume of these markets will migrate to the futures market, where trading is still business as usual. As a consequence, investors and traders in different markets will suffer anyway.
Treating China’s market crash as a separate subject, it could still be argued that the ‘trigger’ point for the circuit breaker was not set at an optimal level. The 5% trigger point set by the China Securities Regulatory Commission may be too low for a relatively unstable market. To exacerbate the issue, the difference between the first trigger and the second is a mere 2%, which in most case, making a second trigger almost unavoidable (Liu, 2016).
DOING SOMETHING IS BETTER THAN DOING NOTHING
Despite the several potential shortcomings associated with the use of market-wide circuit breakers, a few arguments could be raised for its appropriateness as a regulatory tool in the financial markets. The pairing of a plummeting market and the lack of a trading halt may catch traders by surprise, resulting in an insurmountable numbers of margin calls, especially in futures markets. (Greenwald & Stein, 1991). Consequently, the shock of sharply falling prices will result in traders forfeiting their positions in the market, impeding the price discovery process as a result.
Moreover, Ackert (2012) also noted the importance of mandated trading halts on reducing transactional risk, a risk that arises due to uncertainty about execution price. The “cooling-off period” initiated by a trading halt allows buyers and sellers to revise their orders, when current prices in the market do not accurately reflect relevant information.
Another potential benefit from implementing circuit breakers is its role in restoring investor confidence in the capital markets (Subrahmanyam, 2013). Subrahmanyam (2013) asserts that a decline in confidence would result in order imbalances, whereby investors might engage in herd-like behaviour. This behaviour will exacerbate the condition of falling markets as investors rush to exit the market by selling their assets, leading to a shortage of liquidity in the markets. Reiterating the point above, a trading freeze forces market participants to deliberate on the rationality of their actions, thus preventing unnecessary liquidity outflows. Statistics presented in the ASX Australian Share Ownership Study (2015) indicates that only 11% of all investors in Australia are very knowledgeable about share market developments. In contrast, a great proportion of investors possess none to average levels of knowledge of the share market (ASX, 2015). The figures highlighted in the report underpin the need for greater trade halting mechanisms in Australian capital markets in order to extend more protection towards these investors against adverse market effects.
The steady growth of algorithmic trading in Australia is another call for the need for circuit breakers. Algorithmic trading or High Frequency Trading involves the programming of computers to execute trades at speeds and frequencies unachievable by human traders. Algorithmic trading has its benefits such as increasing market liquidity, however, its potential to destroy investor wealth should not be overlooked. An exemplary case of this shortcoming is the Flash Crash that occurred in the United States in 2010. On October 2010, a single “algorithmic” trade triggered a series of automated sales that resulted in American share and future indices declining by 10% in a single afternoon (“One Big, Bad Trade”, 2010). During periods when prices hugely differ from their fundamental values, the objective of circuit breakers is to ensure that assets are not traded at those prices, (Subrahmanyam, 2013). This helps in avoiding any further depression or unnecessary rises in asset prices, which would compound market volatility. Moreover, the speed at which markets operate is faster than ever before due to presence of High Frequency Trading (Baker, 2016). Implementing discretionary market controls are akin to chasing Ferraris on bicycles, therefore automated controls like circuit breakers serve to relieve pressure of markets that stem from algorithmic trading.
CALLBACK
It would be interesting to consider whether a circuit breaker with different thresholds for pausing trading would have had a different impact on the Shanghai and ShenZhen Stock Exchanges. Since the incident, Xiao Gang, the former chairman of the China Securities Regulatory Commission who spearheaded the introduction of the circuit breakers have suspended the use of it and resigned. Whether or not circuit breakers are effective at keeping a stable market, it appears that for China they are not a force for good. Xiao Gang’s replacement, Liu Shiyu, will not be reintroducing the circuit breakers anytime soon.
As global markets become more interdependent, it will be interesting to see how circuit breakers evolve, ideally and hopefully, for the better.
References
Ackert, L. (2012). The impact of circuit breakers on market outcomes. Retrieved from
https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/289039/12-1070-eia9-impact-circuit-breakers-on-market-outcomes.pdf
Australian Securities Exchange. (2015, June). Australian Share Ownership Study [Press release]. Retrieved from http://www.asx.com.au/documents/resources/australian-share-ownership-study-2014.pdf
Baker, N. (2016). Inventor of Market Circuit Breakers say China Got It Wrong. Retrieved from http://www.bloomberg.com/news/articles/2016-01-07/the-inventor-of-market-circuit-breakers-says-china-got-it-wrong
China’s stockmarket crashes – again. The Economist. (2016, January 4). Retrieved from
http://www.economist.com/news/business-and-finance/21685146-chinas-stocks-and-currency-start-2016-big-tumbles-chinas-stockmarket
Greenwald, B., & Stein, J. (1991). Transactional risk, market crashes, and the role of circuit breakers. Journal of Business, 64, 443-462
Kim, K. 2016. What’s Going On With China’s Stock Markets And Economy?. Retrieved from http://www.forbes.com/sites/kennethkim/2016/01/18/whats-going-on-with-chinas-stock-markets-and-economy/#88e033d5d228
Liu, S. (2016). Inside China: circuit-breaker failure. International Financial Law Review.
One Big, Bad Trade. (2010, October 1). The Economist. Retrieved from http://www.economist.com/blogs/newsbook/2010/10/what_caused_flash_crash
Subrahmanyam, A. (2016). Algorithmic Trading, flash crash and coordinated circuit breakers. Borsa Istanbul Review, (13), 4-9
The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.
