Views on the integrity of global capital markets
14 January 2016

China’s Circuit Breaker: Boon or Bane?

Posted In: Market Structure

“Circuit breakers” are safeguards used by stock exchanges to avert panic selling during times of extreme market fluctuations. In September, Chinese regulators introduced draft regulation to put in place this mechanism for the Shanghai Composite Index (SSE). In December, they announced implementation of it would begin on the first day of trading in 2016.

On 4 January, the circuit breaker was put to its maiden test. The Shanghai Composite Index began its downward descent right at opening bell (09:30 GMT+8). At around 13:13 GMT+8, trading was suspended for 15 minutes when prices dropped 5%. Upon trade resumption, prices nosedived another 7% in just over two minutes. As a result, trading was suspended for the rest of the day.

Market participants were taken aback by the extreme volatility. Since the introduction of the regulation, however, there have been two camps — the supporters versus the critics of the circuit-breaker mechanism.

Supporters

Supporters argue for the good intentions behind the mechanism — limiting market volatility and giving market participants time to reconsider their positioning. Supporters of the mechanism believe that by providing investors with a cooling-off period, it will calm fear and panic during steep market declines.

Supporters also argue that the cooling-off period provides time for increased information flow, and therefore the equilibrium between buyers and sellers will be restored. They also feel that given more time, investors will acclimate to the new mechanism and, as a result, there will be a decline in general market volatility.

Critics

Critics, on the other hand, fear the exact opposite. They argue that circuit breakers drain off liquidity and diminish market depth. They also lament that circuit breakers trap investors in their positions given that they are not allowed to engage in equity transactions that would most probably reflect their assessment of the market situation at that moment. Critics argue that circuit breakers might not be so suitable in a retail-driven market such as China’s. Their logic is that when investors are prevented from selling, irrationality and fear will surface, which may lead to more panic selling once trading resumes.

What Did Regulators Say About Opening Day?

Chinese regulators defended their new circuit-breaker system. They argued that the mechanism protects investors and calm markets. However, they said it will require more time before market participants adapt to the new rulings. In addition, the regulators also said the mechanism requires fine-tuning.

Shortest Trading Day Ever … to Date

SSE’s opening day in 2016 was extreme, but 7 January proved even more volatile for the exchange. At 10:03 GMT+8, just 33 minutes after the opening bell, trading was halted for the rest of the day after the Shanghai Composite Index nosedived by more than 7%. Later that day, Chinese regulators announced that they would suspend the new circuit-breaker mechanism until further notice. To date, 7 January is the shortest trading day ever in the 25-year history of the Chinese stock market.

What Should Investors Expect?

Various empirical studies have been conducted in different bourses to quantify the impact that market intervention practices exert on investor behavior. One example would be the study by Tooma and Sourial 2004 on the Egyptian stock market where circuit breakers were found to increase investors’ risk aversion and magnified distortions to market-price movements. The study found that investors react more aggressively towards negative shocks by rushing to the door as fast as possible as prices approach the circuit-breaking threshold.

Another academic inquiry by Draus and Van Achter 2015 using data from developed countries’ equity markets, however, concluded that once the circuit-breaker mechanism was fine-tuned and optimized to properly account for liquidity shocks, it did improve market stability and overall welfare. As can be observed, results from quantitative research is incoherent, subject to the nature of the market participants and the manner in which the circuit-breaker mechanism is being implemented.

Our Take on Circuit Breakers

At CFA Institute, we broadly agree with the practicality for exchanges to have in place the circuit-breaker mechanism to constrain and manage trading activities during times of excessive volatility.

However, we also note that although the circuit breaker is an important safeguard for exchanges to incorporate, they can also be disruptive to trading activity and can slow the price discovery process.

For example, mechanisms to inhibit extreme price movements can impede price discovery at times of breaking fundamental news; as limits are hit, the natural price adjustment process can be constrained. Therefore, the circuit-breaker mechanism should only be applied as a last resort to stabilise markets.

There is always a cost (side-effect) for market interventions — the circuit-breaker mechanism being one example of them.

Because of this, there is a great need for the circuit-breaker mechanism to be implemented in a harmonised fashion across exchanges to provide investors with similar expectations and safeguards on whichever venue they trade. In addition, it would be ideal if exchanges could actively publicise the operating mode of the mechanism. Such disclosure would provide the much-needed transparency to investors over the trading environment and the safeguards present.

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Photo credit: iStockphoto.com/Topp_Yimgrimm

About the Author(s)
Alan Lok, CFA

Alan Lok, CFA, is director of capital markets policy at CFA Institute. He is responsible for conducting research projects in the area of market instruments and market structures in the Asia-Pacific region. Mr. Lok works with regulators, institutional investors, academics, and various other stakeholders within the financial industry to uphold investor protection and market integrity.

6 thoughts on “China’s Circuit Breaker: Boon or Bane?”

  1. Kenny says:

    Hi Alan, interesting article on the role of circuit breakers. Despite its limitations, it is still an essential tool to control volatility in the market especially when china has a lesser history of boom-bust cycle compared to its peers. The level of investor sophistication and knowledge of participants would probably play a role in the effectiveness of such market mechanism. Perhaps the regulators can do more in communicating their policies to the public, more transparency in corporate governance and tools/education to discourage market speculation

    1. Alan Lok, CFA says:

      Thanks Kenny! Both investor education and having more transparency of how intervention tools actually work are evergreen approaches that would do well for all jurisdictions. Once communication among capital market stakeholders improves, they will have the right expectations and with it, hopefully, less pricing volatility in the near future.

  2. Qi says:

    Hi Alan, well-explained article showing both sides of the coin.

    1. Alan Lok, CFA says:

      Thanks Ng Qi for your compliments. Do stay tuned for my future articles related to the Chinese capital markets.

  3. Joshua says:

    This was indeed a big embarrassment for the Chinese regulators. To be honest I dont fault China for experimenting – in fact I think its a positive that they are willing to try out new “western” mechanisms they are normally adverse to. The problem like you correctly pointed out is that chinese stocks are largely dominated by retail investors and a lot more volatile as a result, hence rendering the 5 and 7% limits woefully inadequate.

    A lot of traders/fund managers I spoke to think the limit should be increased to at least 15% to avoid panic selling. Guess an argument could also be made that the two triggers should be much further apart. They did say they were going to fine tune it so I guess its here to stay for at least the short term hence investors looking to ply their trade in the chinese market will just have to used to it.

    1. Alan Lok, CFA says:

      Thanks Joshua. Your comments offer valuable insights because they reflect the view of market participants within your circle. Indeed, based on a recent panel session event we organized in HKUSpace, it is quite obvious that all forms of regulatory interventions are double-edged swords. Their impact on different groups of stakeholders differ remarkably. Not an easy task for regulators.

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