The aftermath of coronavirus has begun to test the often escaped regulatory tools across the world. As economic uncertainty probes into the global bourses, one such sparsely used tool (taken out of the toolkit only 6 times in its 20 years of existence in India) is making its diluted presence aptly felt by halting the free fall of stock markets!
Conceptualized in the United States, back in 1987 post the ‘Black Monday’, it was this tool, termed as Circuit Breakers (borrowing its name from similarly functioning electric switch which automatically operates to prevent damage from current overload or short circuits), which was triggered last Friday as Nifty faced a plunging spree in its early hours of trade. Over the past one week, US markets triggered the circuit breaker 3 times for complete market halt (to put things in perspective, the only time US markets hit the breaker before this was during the Asian financial crisis of 1997 – neither the dot com crash of 2000 nor the financial meltdown of 2008 caused it to activate).
In this piece, we shall look to understand the Circuit Breaker functioning in the Indian context, benchmark global stock market circuit breakers to understand drivers behind its mechanics and assess its magnetic effect.
The functioning of circuit breakers in India
The concept of circuit breaker in India was introduced in 2001 with an objective to create time for market participants to absorb and re-evaluate the available information in times of steep price fluctuations thereby restoring stability, at the same time providing a cushion to manage default risks on margin calls (arising due to extreme volatility).
In India, a nationwide equity and derivative market halt gets activated at three stages of the index movement (BSE Sensex or Nifty 50, whichever happens earlier), up or down, 10%, 15% and 20% for a duration ranging from 15 minutes to full trading day (determined by quantum and time of fall).
A 10% upward or downward movement of Sensex/Nifty prior to 1 pm would halt trade for 45 minutes, the same happening between 1 pm to 2.30 pm, halt is for 15 minutes, post that there is no halt in trading. Well, last Friday’s trading was halted for 45 minutes because the 10% lower circuit was breached by Nifty 50 falling by 10.07% before 1 pm (had it been say, after 2.30 pm, the market would not have halted). It is worthwhile to note that Sensex had till then not breached the 10% limit, but since one of the indices did, nationwide equity markets halted automatically.
For a 15% movement prior to 1 pm, trade would halt for 1 hour 45 minutes. Between 1 pm to 2.30 pm, halt for 45 minutes, post which for the remainder of the day. For a 20% movement, any time, the halt happens for the remainder of the day. Post the halt, the market reopens with a 15-minute pre-market call auction session in the equity cash segment to facilitate price discovery.
Benchmarking global market circuit breakers
One key question that pops up is the determination of trigger limits and halt durations. Well, to understand this it could be useful to look at circuit breakers across key global markets.
If we look at China (Shanghai and Shenzhen stock exchanges), trading halts for 15 minutes when the CSI 300 Index rises or falls by 5% from its previous close for the first time. If the index rises or falls by merely 7% trading is halted for the day (to just draw a parallel, in case of India, 20% is the limit for a complete trading day halt and gaps between break limits are 5% vs just 2% for China)!
Hong Kong follows a “reference price” anchored circuit breaker, the reference price being the price 5 minutes ago (in India, it’s the previous closing price that we use to base comparison). Singapore also follows a 5 minute based reference price mechanism. In Japan, trading halts are for future and option contracts and any derivative products relating to the contracts, with each product having an individual price limit range breaching which a 10-minute suspension happens (for us, the suspensions happen for all equity and derivative products)!
The US has a similar three-stage market-wide halt mechanism as for India, with a slight change in triggers. But, they also have individual stock trigger points, breaching which only that stock stops to trade.
Viewing the variations, the nature and design of circuit breakers can thus, be aptly attributed to three key drivers: investor community sophistication, daily trading volumes, and historic stock market one day movement trend. It is these three, which form the core of trigger point definitions and halt durations. (Honestly, there is a fourth one too!)
Assessing the magnetic effect of circuit breaks
As it is rightly said, too many precautions create an illusion of safety. Take the case of China in Jan 2016, when the too low trigger point for circuit breaks created a situation of constant tripping. The close threshold limits created an attraction effect pulling investors from one breakpoint to the next, like iron filings to a nearby magnet (often termed as the magnetic effect of circuit breaks). Just imagine yourself to be a Chinese trader on a day when markets are approaching the low breach point. What would you do? Most likely, you would sell crazily, trying to get your orders in before the break is triggered and markets are halted. In effect, you help do what you had been trying to avoid!
Hence, managing the magnetic effect of circuit breaks becomes critical for regulators. To some extent, countries’ behavioral dimensions often influence break triggers. (The fourth driver for trigger point determination!)
Of course, Circuit Breaker is a ‘once in an era’ usage tool but the criticality of the ‘era’ when it is invoked leaves less room for making blunders. Last Friday’s rebound of a virtually rolling down index post the halt unequivocally establishes the importance of it for the investor community, and probably that is why regulators keep a close eye on refining them as and when needed.
About the author: The post is written by our EZPP partner Aayush Jhawar with relevant edits and changes by our editorial team. Aayush has graduated from SPJIMR and currently works with the Boston Consulting Group.
Disclaimer: All views expressed in the post are personal, and not related to any organization to which the writer belongs.