Time to question circuit breakers

Financial Express, 19 May 2009

18 May 2009 was the reverse of 17 May 2004. On both days, circuit breakers were triggered on NSE and BSE. Basic questions now need to be asked about the circuit breaker regime. One of the many tasks of financial markets is to always be there, and this is particularly important on news-rich days like these. Circuit breakers interfere with this function, in return for benefits which are hard to see.

Circuit breakers are supposed to help market participants take a pause and digest information when dramatic developments have taken place. The `circuit breaker' rules that were defined by a SEBI circular in 2001 have defined three triggers of 10%, 15% and 20%. These trigger off either a trading halt, or a closure of trading for the day. The term `circuit breaker' sounds sophisticated. However, such market rules are fraught with difficulty.

Uptime is a crucial dimension of financial markets

A well functioning financial market plays two valuable roles:

Price discovery
The process of buying and selling yields a price. As an example, on 18th, it was very important and interesting to know: How much is this news worth in terms of the overall change in Nifty? One might expect companies who were close to cabinet ministers who have reduced influence to come out losing more on the stock market. This motives the question: Which companies stand to lose from this change in guard?. Economic reform will brighten the outlook for some industries, which motivates the question: Which industries have fared better?.
The continuous flow of price information makes financial markets one of the most critical components of the statistical system. This information is used by a broad range of decision makers. When this information is snuffed out by a circuit breaker, there is a cost.
Market as a source of liquidity
In response to news, many people desire adjustments in their portfolios. In particular, people holding an options portfolio, which is hedged using futures, require a continuous supply of liquidity. If prices change while trading is infeasible, then this hedging -- which is basic to the production technology of options -- breaks down. Market closures directly do damage by interrupting the continuous supply of liquidity.

A critical feature of properly functioning financial markets is, thus, the feature of being there. The financial market must function continuously at all times, without interruption of service. The existing circuit breaker regime contradicts this function. When news breaks, and financial markets are needed most, circuit breakers interfere with the functioning of the market.

Whether it was 17 May 2004, 26 November 2008 or 18 May 2009: some policy makers have been quick to suggest shutting down financial markets. The short-term benefits (analogous to shooting a messenger) need to be weighed against these manifestly visible costs.

Alternatives to NSE trading in Nifty futures

When an exchange is the only game in town, shutting it down matters. But when trading takes place at multiple venues, shutting down one merely shifts order flow to other venues. In 2009, there were three important differences when compared with 2004:

  1. A buildup of liquidity with Nifty futures in Singapore had taken place (which, in turn, was caused by the earlier restrictions on participatory notes). So when circuit breakers shut down Nifty futures trading at NSE, some of this order flow migrated to SGX. When an onshore market suffers from interruptions of service, while an offshore competitor does not, this is a competitive disadvantage for us.
  2. Another trading venue which has gained in importance in recent years is the ADR market. Some of the order flow (either from locals or from foreigners), which was prevented from hitting the market in India owing to the circuit breakers, would have showed up in the ADR market when it opened.
  3. Currency futures trading was available at NSE. To some extent, people who could not trade in Nifty futures used currency futures as a rough Nifty proxy. NSE's currency futures turnover went up on 18 May to an all time high of over a billion dollars. Some of this was caused by the interruption of service on trading in Nifty.

Alternatives for reform

Looking forward, two positions can be taken in reforming the system. The first position is that there is nothing wrong with a continuous market; market-wide closures should not be done. This is a reasonable position and should be carefully considered.

If it is felt that in times of extreme movement, market participants really deserve a pause to ponder the world, there is a superior alternative to closure. This is the `call auction' market. We could have a rule saying that when Nifty moves by more than 10%, we will go into a call auction for 15 minutes.

In a call auction, buyers and sellers place or modify their orders, and the system continuously shows a provisional price, at which the supply and demand curves intersect. So for 15 minutes, orders would build up for both buy and sell, and a single market-clearing price would be continuously computed and displayed. When the 15 minutes end, the market-clearing price that is discovered reflects a large number of orders and is hence more trustworthy. At the end of this period, a single price is announced and all orders that satisfy this price are matched. The remaining unmatched orders are a thick order book, and represent an ideal starting point of a liquid market for continuous trading.

Summary

If one is optimistic about the ability of financial markets to continuously discover a price when major news breaks, then one would veer towards having no closure. Even if one feels that a 15 minute pause is desirable, with a special effort at discovering a trustworthy price running through this pause, this suggests dropping out of the continuous market into a 15-minute call auction every time there is a 10% move of Nifty. Both these alternatives are better than the existing system of circuit breakers, which interfere with a core function of financial markets: that of being there.

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