Do we need circuit-filters?

Anup Menon

ASK anyone with a basic knowledge of the stock markets on the circuit-filter, the probability of the person replying positively is quite high.

Normally when a stock hits the circuit-filter and stays there for some time, investors interpret this as ``something is happening'' in that counter. So why do stocks hit the circuit-filter limits.

For instance, between December 5 and 20, 2000, the Bank of Madura stock rose from around Rs 90 to around Rs 290, translating into Rs 200 gain in 12 trading sessions. Why did the stock hit the filter so frequently?

At around this time, the managements of Bank of Madura and ICICI Bank had come to an agreement to merge. Moreover, the swap ratio was fixed at 2 shares in ICICI Bank for every share held in Bank of Madura. Logically this means that post-merger the value of Bank of Madura stock is much higher than what its was trading at in early December. However, it took around 10 trading sessions for the stock to reach close to its expected fair value. The obvious reason is the cap imposed by circuit-filters.

Filters and breakers: The 1987 crash in the US stock markets had important repercussions in terms of surveillance measures. Several stock exchanges adopted circuit-breakers. The system stops trading activity if and when prices move beyond a specified range. The intention of introducing the circuit-breaker was to reduce overall volatility levels by stopping order flow and help improve market liquidity.

A major characteristic of circuit-breakers is that it halts trading when the limits are reached. On the contrary a circuit-filter is a ceiling fixed on price movement. In other words assume a stock is trading at Rs 100. If the circuit ``breaker'' level is around 5 per cent, then trading will stop if the stock touches either Rs 95 or Rs 105. If the circuit ``filter'' level is around 5 per cent, then it only means that traders cannot bid/ask quotes below Rs 95 or above Rs 105. Hence, if traders are willing, they can still trade within the prescribed band. How does this happen?

Information effect: In most cases stocks (liquid and actively traded ones) stay frozen because the markets anticipate a change in the fundamental price of the asset. Here information plays a critical role in the price formation process. Asset prices tend to value information and adjust immediately to maintain the equilibrium price.

Circuit filter: A perceived benefit on account of the presence of circuit-filters for traders and investors alike is that erosion/accretion of wealth is not as rapid compared to when circuit-filters are not present. However this may not be true in all cases.

For instance, if we look at the table of stocks hitting the circuit-filter during the course of the day, we would find stocks where the high and low prices are equal. This should mean that trading in the stock was frozen for a substantial part of the trading. In the case of the Bank of Madura stock, it hit the upper filter for many days at a stretch.

The reason why stocks usually remain frozen at one end of the circuit-filter is that traders are not willing to enter into trades at prevailing levels. In the Bank of Madura case, buyers could not find sellers. This is rational. If you were a seller and have information that a stock is valued at Rs 150, would you sell it at Rs 100?

Saying `no' to filters: Therefore the question is: Are circuit-filters essential in such situations? Probably not. For instance when information on the true value of the stock is publicly available, it would make perfect sense for the market to realign itself. The need for circuit-filters can be questioned on several grounds. For instance, empirical evidence on the effectiveness of price limits, circuit-breakers and trading halts is ambiguous. But in the case of specific situations where it is clear that the equilibrium value of the asset will change, as in the Bank of Madura's case, it makes no sense to set circuit-filter limits. In fact, it goes against the objective of improving liquidity in the market. In the absence of artificial price limits, the prices would have realigned sooner, thereby bringing more liquidity in to the market.