Tempering the impact

B. Venkatesh

Anup Menon

There is instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on mathematical expectation, whether moral or hedonistic or economic. Most probably... the full consequences... can only be taken as a result of animal spirits -- of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. -- John Maynard Keynes in The General Theory of Employment, Interest and Money(1936)

THE several market crashes that occurred in the past happened despite market experts and economists advising investors not to sell in panic. As Keynes observes, this could be a reaction of the animal instinct within human beings.

This is the primary reason that stock exchanges the world over have introduced measures within the trading mechanism to reduce the impact of temporary market aberrations. One useful tool is the market-wide circuit filter. A circuit filter is a rule that halts trading if the market hits a pre-specified limit.

Crashes and market viability

The prime reason for the sell-off in the market during a crash is the information effect of that particular event and its implications for the market as a whole. In the wake of an event, investors change their views on the expected value of the stock.

Their new expectations are based on the potential implications of the event on the stock(s) they are holding. It should also be said that the information on which they have based their decisions is not fully perfect. In other words, there are some uncertainties that are still not addressed. Therefore, trading activity takes place only on market prices factoring in a premium or a discount in selling or buying stocks.

For instance, the Nasdaq crash of April 2000. Investors knew it would have a negative impact on software stocks. Therefore typical investors in software stocks, fearing further declines, probably wanted to sell and move into cash.

But, in such instances, the question is whether the investor can find a buyer at the market price. Probably not! Why? Any buyer will take the stock only if it comes at a significant discount, the discount being compensation for the additional risk he has to bear on account of the uncertainty.

Imagine what would happen if such a situation exists across all stocks and sectors traded in the market. All the buyers will beat down the price of stocks, which result in the market crash. To temper the severity of the crash, stock exchanges impose trading halts. Such trading halts come in the form of circuit filters.

Circuit breakers: Global evidence

On October 27, 1997, circuit breakers caused the New York Stock Exchange (NYSE) to halt trading for the first time in history as the Dow Jones Industrial Average (DJIA) crashed by 554 points. The market-based circuit breaker system was born out of the market crash of 1987. Suggestions to control volatility during times of market stress invariably focussed on market-wide trading restrictions.

The restrictions can be in many forms that include margin requirement, price limits and market-wide trading halts. Specifically, Rule 80-B at the NYSE specifies the rules regarding trading halts at the NYSE. According to the rule, trading will be halted if the DJIA declines by a predetermined amount within a single day.

The question is: Are circuit breakers a good policy measure to control the market? Arguments in favour of the circuit breakers are that it gives the market some time to adjust its views by digesting the information coming into the market. Hence, when trading re-opens, investors would be more rational and the price adjustment process less chaotic.

Researchers who argue against this point to the `magnet effect', which implies that traders fearing a halt in the market may try to get out of their positions before the trading halt occurs. This means they would be willing to take larger discounts for the purpose of moving into cash before the trading halt. This, in turn, would lead to more severe price pressure, hastening the trading halt.

Circuit-breakers in India

Circuit-breakers have always been present in the Indian trading system for individual stocks. Market-based circuit-breakers were recently introduced in India. On September 12, 2001, the day after the terrorist attack in the US, SEBI fixed the market-wide circuit filters at 10 per cent of the Sensex and the S&P CNX Nifty. It could, however, be more useful if there was a rule similar to the one prevailing at the NYSE.

For instance, if the market is at 3000 and the circuit breaker limit is 10 per cent, trading will be halted only if the market crashes by 300 points. This would change depending on the base of the index. For instance, if the index was at 10,000, then the trading halt would be triggered only if the index falls by 1000 points, which is an unlikely event.

Trading halts could, however, be effective if rules specify specific point levels rather than percentage levels. For instance, the rule could state that trading would be halted if the Sensex falls by 350 points. While trading halts can prove to be useful to mitigate temporarily the negative impact of a crash, their effectiveness tends to be limited.