China must update, not lose, its circuit breaker

China’s response to its bungled circuit breaker should be to design one more suitable to Chinese markets, not do away with it

 
An investor reacts at a stock exchange in Haikou, China. Circuit breakers in China have been a point of contention around the world since being implemented 

Chinese equities had a rocky 2015. The year saw China’s stock prices climb before rapidly falling, and falling again and again, eventually causing a downward trend in markets around the world, from Tokyo to New York. To restore confidence in both the Chinese economy and the ability of the comrades tasked with managing it, Chinese authorities drew up a number of new financial regulations, hoping to tame their wild stock markets. This included the introduction of a circuit breaker mechanism, otherwise known as a trading curve, which was launched when markets reopened in January 2016.

When the index of a certain market either climbs too high or dips too low in a certain amount of time, trading is either suspended periodically or for the rest of the day, depending on the size of the swing

Almost immediately after trading started, the newly minted circuit breaker came into effect. Circuit breaker became the new buzzword of early 2016. They work as limits to how much the stock market can swing – usually, but not always – downward. When the index of a certain market either climbs too high or dips too low in a certain amount of time, trading is either suspended periodically or for the rest of the day, depending on the size of the swing.

China’s circuit breaker was intended to come into effect after a seven percent market fall, suspending trading for 15 minutes. Following the reopening of the market, if numbers fell by a further two percent, markets would close for the duration of the day.

However, the circuit breaker – intended to bring calm to Chinese bourses – failed. Chinese stocks took a battering in the mechanisms’ first few days of use, resulting in markets seeing two day-suspensions in just four days. On one occasion, on January 7, the circuit breaker forced an end of trading for the day less than 15 minutes into the start of trading. As a result, Chinese regulators soon dropped the circuit breaker.

Start of the circuit
Circuit breakers exist in most stock markets globally. The size of the swing needed to trigger the circuit breaker varies, and is often deliberated over by financial authorities. While they are generally accepted as a feature of modern financial markets, some regions, including Hong Kong and Australia, remain circuit breaker free. Modern international financial markets as we know them came into fruition properly in the 1980s, particularly following the 1986 regulatory ‘big bang’. And with the advent of modern international stock markets came the advent of international financial crisis.

In the US, following the Black Monday global crash of 1987, a Presidential task force was set up to investigate the crisis and how to prevent – or at least reduce the chances of – a similar calamity happening again. It was hoped that, in the face of a newly inter-connected financial world, where shocks from one country would be felt around the globe and where modern communications were providing constant news updates and new trade orders, circuit breakers would provide buyers and sellers with a period of calm.

The mechanism was introduced to US markets in 1989, and was first triggered in 1997. And as with China, it was said to be causing more problems than it prevented. For instance, a 1997 Slate article covering the first trigger of the NYSE circuit breaker noted that traders themselves felt that the circuit breaker had actually exacerbated the situation: “In the heat of last Monday’s stock-market dive, the New York Stock Exchange debuted circuit breakers. Reviews of the procedure, which halts trading when the Dow Jones Industrial Average drops dramatically, are mixed. Most traders say that the pauses exacerbated the panic. Treasury Secretary Robert Rubin and others credit the pauses with calming jittery investors.”

Spectre of suspension
When it comes to regulation – particularly financial regulation – there is a well known rule that market actors will, rather than being curbed by regulation, incorporate them into their market decisions, often with unintended consequences. This was the primary problem with the circuit breaker. It actually caused greater panic selling – the opposite of what it was intended to do.

According to Slate in 1997, the consensus on Wall Street was that the circuit break encouraged traders and investors to sell even more, rather than cooling off: “During the first lull, traders who had orders to sell by the end of the day were already anticipating a second circuit breaker. Fearing that a second circuit breaker would close the market for the day and prevent them from executing their orders on advantageous terms, they sold their stocks as soon as possible instead of waiting to find the best price.”

The same was the case with the Chinese circuit breaker: for a Chinese trader incorporating the new regulation into his or her behaviour, it made off-loading large amounts of shares a logical choice. Upon seeing a market decline approaching the five percent figure that would trigger the breaker, it would make sense for the trader to rush to place his sell orders before markets suspend. In a self-fulfilling prophecy, the trader’s fear of a suspension would make such a suspension even more likely.

Following that and the reopening of markets after the 15 minutes of supposed cooling off, the next fear would be that the market would decline further again. Should a further two percent decline happen, the market would close for the remainder of the day, creating even greater selling urgency.

This would then encourage further panicked selling once again, making the triggering of the final day-long suspension more likely. The spectre of a potential circuit break suspension becomes the very cause of a suspension.

However, that is not to say that circuit breakers themselves are always susceptible to such unintended – or rather actively opposite – consequences. Regulations are only as good as their regulator has designed them – and Chinese regulators designed theirs badly. The initial triggering figure was set too low for the reality of China’s volatile stock markets, where dips in the market approaching five percent are fairly common.

With relatively un-extraordinary markets falls being so near to the circuit breaker figure, it creates a magnetic effect, pulling the market down and resulting in a suspension. And with the second circuit breaker figure not far off, the second trigger becomes even more likely.

Use only in an emergency
After circuit breakers caused a similar self-fulfilling prophecy to grip New York markets in 1997, the proper role and triggering-levels of circuit breakers came under intense scrutiny. In 1998 Arthur Levitt, the chairman of the US Securities and Exchange Commission, testified before the Senate Committee on Banking, Housing and Urban Affairs and said: “For circuit breakers to be of any value, they should be used only on those rare occasions when the market decline is of historic proportions and, as a result, the markets and supporting technology are headed for disarray.”

Only extraordinary circumstances should warrant a circuit breaker trigger, such as a “severe market decline when the prices have dropped so dramatically that liquidity and credit dry up, and when prices threaten to cascade in a panic-driven spiral.”

Since the late 1990s, the US financial authorities have continuously tweaked and debated the right levels for circuit breakers. Since 2012, the SEC has been working on more targeted circuit breakers, which will set price fluctuation limits on individual securities, known as the Limit Up-Limit Down Plan for Individual Securities.

At the same time, High Frequency Trading and how that will affect and can be incorporated into circuit breaker rules is an issue increasingly being explored by regulatory bodies. Without constant revision and adaptation to changing or differing markets, circuit breakers become crude and blunt instruments.

China’s market – as with other markets – would benefit from circuit breakers; but only well thought out ones, tuned to Chinese market conditions. Current US circuit breakers – and others around the world – do not provoke such chaos as in China in 2016. The numbers at which it was decided that the circuit breaker would step in and shut down trading were clearly too low.

The peculiar nature of the China’s Shenzhen and Shanghai equities markets, however, makes implementing a successful circuit breaker a slightly more challenging task for authorities.

Chinese markets are not dominated by big institutional investors or hedge funds, as in the advanced economies, but rather, are replete with short-term retail investors. Such investors often do not make orders based on fundamentals, but just follow swings in the market, making them more prone to panic selling.

That being said, Chinese authorities should not give up on this essential safeguard of modern financial markets – they should develop and adapt them to the conditions and structure of their own markets: circuit breakers with Chinese characteristics.

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