The circuit breaker in China – a “trading curb” designed to calm fears of a market collapse by affording a “cooling” period before trading of stocks is resumed – was heavily criticized for exacerbating market volatility after it was triggered for the first time on January 4 and again on January 6. The four days between introduction and suspension of the mechanism on January 8 are a reflection of the current state of investor confidence in the Chinese stock markets and China’s economy
By Kenny Lau
Following a mid-summer Chinese stock market crash in 2015 when a total value of some 40 percent diminished at one point, an unfinished market correction in stock prices appeared to have forged right ahead, crossing over to the new year, despite China’s repeated attempts to alleviate pressure through purchases of domestic financial assets and to guard against an “unreasonable plunge” in share prices through a six-month ban on selling stocks of listed companies among major shareholders owning five percent or more.
As the ban on selling shares in China’s multitrillion- dollar stock market from July ended earlier, a mechanism called market circuit breaker was introduced on New Year’s Day. The purpose was to put a halt to a sudden and drastic swing of stock prices in the Shanghai Stock Exchange, Shenzhen Stock Exchange, and China Financial Futures Exchange, thereby maintaining market stability in a way very similar to other leading stock markets worldwide.
The circuit breaker in China – essentially a “trading curb” designed to calm fears of a market collapse by affording a “cooling” period before trading is resumed – would be activated for 15 minutes when the CSI 300 Index moved up or down by five percent or more, and for the remainder of the day if it fluctuated by seven percent or more. It was put in place to stoke investor confidence but only lasted several days before it was scrapped amid a panicky market in early January.
The circuit breaker was heavily criticized for exacerbating market volatility after it was triggered for the first time in the afternoon on January 4 and again on January 6 less than 30 minutes after the Chinese stock markets opened. The CSI 300 Index was down 11.7 percent within the first four trading days of the year. And it was reported two weeks later that Chairman of the China Securities Regulatory Commission (CSRC) Xiao Gang had offered to resign – a report CSRC said was inaccurate.
Criticism & reality
Critics have pointed to the “magnet effect” of the circuit breaker due to the aspect of a “deadline” before activation as a cause for investors to frantically unload their shares of company stocks, and many agree the expectation of calming market chaos using a circuit breaker appeared to have had the opposite effect this time.
Other have also categorized the threshold of market fluctuation for activation of trading suspension to be comparatively low, given how the Chinese stock markets had dropped more than five percent on a single trading day some 30 times and more than seven percent nearly a dozen times throughout 2015. Perhaps the limits could have been set slightly higher; but doing so could have made no difference, while a high threshold would have defeated the purpose of a circuit breaker altogether.
What’s clear and more important, in turn, is that it says a lot about investor confidence in the Chinese stock markets and China’s economy at the moment. “Any new circuit breaker, no matter how well crafted, will not work well in the troubled period that is immediately ahead,” Gordon G Chang, an expert on China, wrote in Forbes magazine. “The overriding reality is that Chinese stocks, despite the carnage in the markets [in early January] and last year, are still overvalued. The adjustment downward will therefore be especially difficult.”
“And the overvaluation is not insubstantial,” Chang noted in his article. “The median Chinese stock listed on the Shanghai and Shenzhen exchanges is trading at over 60 times earnings. That is more than three times the median multiple of stocks on the New York Stock Exchange. In India, a country with far better growth prospects than China, the average multiple is under 25.”
“The Chinese economy is trending downward fast, which means stocks prices should tend to fall quickly, even in the unlikely event that stocks can keep their current multiples,” he further said. “Moreover, money is gushing out of the country and the currency is falling fast, so the Chinese will be looking to unload Shanghai and Shenzhen stocks.”
Challenges & effects
The implementation – and suspension just four days after the initial debut – of China’s circuit breaker, nonetheless, has highlighted concerns among investors over emerging risky “consequences” amid the market conditions following the introduction of the mechanism to the Chinese stock markets, reflecting a negative impact particularly on securities firms, according to an analysis by Moody’s Investors Service on the decision by China’s regulators to scrap the circuit breaker.
Firstly, by cutting off trading in the stock market, whether planned or not, it fuels “the threat of a sharp reduction in market liquidity,” analysts at Moody’s point out. “Once the circuit breaker is triggered, trading stops for all stocks, including blue-chips stocks, which are the most liquid, closing down a key channel that investors could use to dispose of their shares.” In other words, when liquidity – hard cash or otherwise – dries up, transactions come to a halt, bringing the market down to its knees.
Secondly, it challenges “the risk controls of securities companies with respect to their margin loans and other stock-pledged financing,” meaning firms engaged in securities trading are vastly impeded in their ability and flexibility of “mitigating losses in a volatile market” when a circuit breaker is activated. It is a scenario in which firms become unable to offload collateral and securities purchased with margin loans in case borrowers fail to honor their obligations, Moody’s explains in the report.
Furthermore, not only does it limit liquidity as the circuit breaker sets in, but it “threatens to drastically reduce market trading volume as well as the brokerage commissions of securities companies” as a result, Moody’s says. The trading volume of stocks in China on January 7 (one day before the circuit breaker was scrapped), for instance, was down to RMB 188 billion because of the shortened trading time, falling by more than 80 percent from the average daily volume of RMB 1.05 trillion in 2015.
The current environment for securities companies in China remains challenging as it is for anyone trading in the stock market. The good news, as noted by Moody’s, is that “securities companies still maintain material collateral buffers even after the sharp market correction seen in [those] four trading days.” The average margin maintenance ratio – market value of cash and securities in hold minus expenses – among Chinese securities firms remained high at 245 percent, with margin loans totaling RMB 1.12 trillion as of early January, indicating “the industry’s improved risk management and resilience.”
The question then becomes whether China’s circuit breaker was inherently flawed in design or whether it was just bad timing. There are proponents and opponents on both sides of the coin, arguing how, on the one hand, it prevented the market from sliding down further and, on the other, it prompted portfolio and fund managers to sell needlessly before it was deemed too late. Regardless of market sentiments, a more refined circuit breaker could potentially provide a safeguard in the long term.
In fact, there are pre-existing rules governing trading on individual stocks. And these rules are more specific than the “all-or-nothing” approach prescribed in the circuit breaker, including the “limit-up limit-down” scheme preventing a stock from being traded 10 percent above or below its previous closing price, as well as the “T+1” rule which bans selling of shares bought on the same day. The circuit breaker, in retrospect, might have been counter-intuitive but it could be updated to complement existing rules to become far more effective.
Circuit breakers in stock markets worldwide have had a relatively short history, and they vary in each market. The idea was first contemplated in response to the market crash of October 1987, with the Dow Jones Industrial Average (DJIA) falling 508 points, or over 22 percent, in a single day. And, in October 1989, a circuit breaker was implemented in the New York Stock Exchange “to reduce volatility and promote investor confidence.”
The first circuit breaker in the US was initially based on movement of actual DJIA points, but it switched to the current percentage-based system in 1997. The US Securities and Exchange Commission in May 2012 approved the “Limit-Up Limit-Down” mechanism to “prevent trades in individual securities from occurring outside of a specified price band…triggered by large, sudden price moves in an individual stock.”
The mechanism calls for a gradual halt rather than an abrupt stop. The price band is set at a percentage level above and below the average price of a given stock in the preceding five-minute trading period. Price bands are five percent, 10 percent, 20 percent, or the lesser of $.15 or 75 percent, and they double during the opening and closing hours of the trading day. A five-minute trading suspension is activated if the price of a stock doesn’t move back within the price bands within 15 seconds.
Market-wide circuit breakers are also in place in the US “for coordinated cross-market trading halts if a severe market price decline reaches levels that may exhaust market liquidity…as measured by a single-day decrease in the S&P 500 Index.” The thresholds are seven percent (Level 1), 13 percent (Level 2), and 20 percent (Level 3) – all set by the markets at point levels that are calculated daily based on the closing price of the S&P 500 Index of the previous day.
If a market decline reaches Level 1 or Level 2 before 3:25 pm, a 15-minute pause kicks in, while the market-wide circuit breakers will not be triggered at or after 3:25 pm. A market decline at Level 3 at any time during the day will halt market-wide trading for the rest of the day. A halt in trading amid high market volatility can make a difference because “investors are given time to assimilate incoming information and the ability to make informed choices,” especially when trading occurs so quickly and colossally in a world more automated than ever.