A short-lived circuit breaker was Beijing’s latest attempt at propping up the country’s plummeting stock markets
2016 has had an astonishing new year for many reasons. The global stock market's more than seven percent slide in the first half of January ranks as the worst start in decades. China, unfortunately, has been attracting most of the blame. In the first 10 trading days of the year, the benchmark Shanghai Stock Exchange Composite Index (SHCOMP) fell more than 600 points, or approximately 18%, causing repercussions across the globe.
The downward pressure on China's stock market has many folds; its pessimistic economic outlook, continued depreciation of renminbi, a build-up of capital outflow, overvaluation of listed companies, the expiry of a six-month moratorium on selling by large shareholders that was implemented last July, and, of course, market psychology. Of the many factors playing on investors' nerves, the short-lived circuit breaker mechanism is a notable one.
The circuit breaker
Discussions for a circuit breaker commenced last September as one of the many regulatory responses to the persistent slide of stock prices since June. In December, the Shanghai Stock Exchange, Shenzhen Stock Exchange and China Financial Futures Exchange issued rules for implementation of a circuit breaker mechanism to become effective on January 1 2016. The circuit breaker, as provided in these rules, involves both limit-up and limit-down cross-market suspensions of trading based on fluctuation of the CSI 300 index. CSI 300 tracks the largest companies on both the Shanghai and Shenzhen bourses, and is generally regarded to be less susceptible to volatility. There are two fuse levels. When CSI 300 fluctuates up or down five percent or more, cross-market trading shall be suspended for 15 minutes (or the markets close if the fuse level was reached within 15 minutes of regular market close). If volatility reaches seven percent after reopening of trading, the markets shall close for the day.
Unexpectedly, but not entirely surprisingly, the circuit breaker was tripped almost immediately. On January 4 2016, the first trading day of the year, trading was suspended at 1:13pm for 15 minutes following a five percent slide of the CSI 300. Then, within minutes of reopening, at 1:34pm, stock markets closed following a further two percent loss of the CSI 300. On the same day, major indexes in the US, Europe and Asia all experienced significant losses. What ensued on January 7, the fourth trading day of the year, stunned everyone. Just 13 minutes into trading, the CSI 300 fell five percent, triggering a 15-minute suspension. When trading resumed, it took all but one minute for the CSI 300 to burn out the second fuse. The entire trading day lasted 29 minutes, the shortest ever, and trading was open for about 14 minutes. The global stock market took another severe beating. The same evening, the circuit breaker was suspended indefinitely.
The circuit breaker was introduced to reduce volatility, but may have acted to accelerate price movements in the market. Theoretically, the circuit breaker should function to:
- provide a cooling-off period, so that investors can have more time to obtain and digest news and other information, make informed trading decisions and avoid panic reactions;
- prevent automated trading programmes from exacerbating market volatility while following pre-set algorithms; and,
- allow regulators and exchanges time to provide more information to the market or fix technical glitches.
In practice, however, the existence of a market breaker may create a mental target and drag investors towards the thresholds. The expectation of a likely trading halt will alter investor strategies, and, in a downturn, scare away potential buying powers and drive up selling.
Circuit breakers are a double-edged sword, and should only be invoked in extreme situations and with caution. By definition, the activation of a circuit breaker immediately blocks liquidity and interrupts the price discovery process, two key functions of stock markets. Investors may become trapped in existing positions, unable to further transfer risks or realise profits. By unexpectedly depriving market participants the opportunity to raise liquidity, it may also cause chain defaults of other obligations. These obligations may include redemptions of mutual funds, payments of debts, or fundings of acquisitions – the default of which may spread costs, risks and panic to realms much wider and deeper than stock markets. Fundamentally, artificial interruption of a stock market caused by a circuit breaker are no less detrimental than undesirable volatility.
"An artificial floor of stock prices should not be maintained, cannot be sustained, and will cost dearly"
Certain elements of the circuit breaker as implemented by Chinese regulators were apparently faulty. First of all, the five percent fuse level was too low. The country's stock markets are more volatile than those of more developed markets, and a five percent fluctuation either way is not that rare. Second, the margin between the two fuse levels was too narrow. Once a suspension is triggered at five percent, a breach of seven percent becomes almost inevitable. These faulty design features, coupled with the so-called magnet effect, reduce a full market closure trigger to effectively about four percent. As observed on both January 4 and 7, once the CSI 300 approached a four percent drop, the looming five percent trigger created an expectation of continued decline and market closure. Buyers turned away and there was a rush to sell, putting immense pressure on market liquidity. As a result, price movements are aggravated when a circuit breaker is in place. It first drags the CSI 300 down from four percent to five percent, and then, when trading resumes following the suspension, from five percent to seven percent at increasing speed. Frequent market interruptions are clearly unsustainable, and to the market's relief, the circuit breaker mechanism was quickly swept under the carpet after just seven days of operation.
Ultimately, if a circuit breaker mechanism is to be implemented, it should be formulated in line with the goal of curbing extreme volatility while posing minimum interruption to market operation. In this regard, a comparable circuit breaker mechanism approved by the US Securities and Exchange Commission (SEC) would be worth studying. This is set at three levels: seven percent (level 1), 13% (level 2) and 20% (level 3), as measured by single-day decreases in the S&P 500 Index. A market decline that triggers a level 1 or level 2 circuit breaker before 3:25pm will halt market-wide trading for 15 minutes, while a similar market decline 'at or after' 3:25pm will not halt market-wide trading. A market decline that triggers a level 3 circuit breaker, at any time during the trading day, will halt market-wide trading for the remainder of that day. Given that US stock markets are far more mature and the S&P 500 far less volatile, the likelihood of tripping a level 1 circuit breaker is quite remote. In addition, the gaps between breaker levels are much wider, so they should stand a good chance fending off the overwhelming magnet effect.
China's debate about the mechanism is still ongoing, and we may see the revival of a circuit breaker in an alternative formula. Many, however, question whether a market-wide mechanism, irrespective of its formulation, would add much to the volatility curbs already in existence. For example, there's a general daily price limit of ±10% of all A shares (±5% for stocks under special treatment), pursuant to which, the trading of an individual stock will be suspended for the day if the price moves beyond the limit. In addition, the settlement cycle of A shares is T + 1, effectively prohibiting same day turnaround trading.
The circuit breaker is one of many failed regulatory interventions put in place to bolster stock prices since last summer. Facing continued market losses in the first weeks of 2016, new responses also include a further injection of liquidity and extension of disposition restrictions on large shareholders. While reflecting on these regulatory initiatives, it is perhaps a good opportunity to also consider the validity of the interventionist approach towards stock markets.
A stock exchange is an important component of the capital markets and serves many indispensable functions. It provides liquidity and marketability to securities and underlying illiquid assets, it offers a price discovery system, it creates investment channels for household savings, it reflects an economy's performance and outlook, the list goes on. Irrespective of the approaches used to evaluate equities, by nature, stock prices reflect the fundamental economic value and outlook of listed companies and the broader economy, even though such correlations may not be instantaneous or exact.
Regulatory interventions, in essence, are artificial market manipulation measures. They should only be employed to gently adjust the movement of fundamental economics or to prevent truly catastrophic events. Any regulatory measures to micro-manage stock prices are inherently inefficient, self-defeating and unfair. Unless a regulatory intervention programme impacts the underlying macro economic environment, any effect it may have on stock prices will only be temporary and will create latent pressures on stock prices when such intervention expires or can no longer be sustained. Such measures require deployment of immense public resources, be it monetary input or interruption of normal functions and existing orders. Such measures are selective, they signal that stock investors are entitled to some kind of state protection not otherwise available to investors in other sectors of the economy, or that some companies are entitled to state protections ahead of others, all of which will eventually be paid for by the broad public. In addition, such regulatory intervention may give rise to undue advantages, corruption, collusion and insider trading, further distorting the market and dampening market confidence. All in all, an artificial floor of stock prices should not be maintained, cannot be sustained, and will cost dearly.
|Inside China, written by FenXun Partners' Xusheng Yang and Sue Liu, is an insight into aspects of the China market that often elude the naked eye.|
Yang is a specialist in China's financial markets and institutions, having started his career at the China Securities Regulatory Commission and then co-founding FenXun in 2009. Liu's practice focuses primarily on the asset management industry, and has previously worked as an associate at Skadden Arps Slate Meagher & Flom in New York.
Instead of trying to shore up stock prices when correction is due, the attractiveness of stock markets should be maintained by providing a fair, efficient, transparent and consistent trading environment. Competent stock market regulation should include the implementation of rules, guidance and supervision that ensure this backdrop. Stocks investors, like all investors, should acknowledge investment risk and return trade off. Their investments, as a whole, are not entitled to state protection. Instead, protection of small investors' rights should be in the form of fair and adequate disclosure, actions against misrepresentation, insider trading, market manipulation, public education of investment risks and trading rules, and policy inducement towards long term, value-based investment. When economic conditions change, stock prices should be allowed to fall to a level that attract new investors or rise to a level that promote exit of investors. Similarly, overvalued companies will have to either grow into their valuation or experience price decline. Non-performing companies should be allowed to fail and reorganise.
Furthermore, stock market regulation should be cautious and consistent. In an environment where focused regulatory intervention becomes frequent and sudden, uneasiness towards regulatory policies and their effects grows, which adds a level of uncertainty and transaction cost to the market. Back in summer, a ban was imposed on the sale of stocks by major shareholders and insiders of listed companies. If this ended on January 8, as originally planned, it could have freed up an estimated CNY 1.2 trillion worth of shares for sale. The crash on January 7 was partially caused by fear that its expiration might lead to a massive institutional dumping of shares. In response, regulators extended the ban for three months, albeit in the form of a selling restriction of up to one percent of a company's shares. The extension may have prevented another crash in the short-term, but the problem remains. What should regulators do if economic conditions don't improve when the three-month period ends? And how should investors strategise in response?
History has proven, time and again, that market interventions are futile in the long-run, and that market cycles and corrections are unavoidable. There is an important lesson to be learned from stock market events of the last twelve months: regulations should never be used as blunt instruments to battle against market forces, regulators should function as the strong protector of the market and, only rarely, as a gentle helping hand.
By FenXun Partners' Sue Liu in Beijing
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