The Hindu Business Line : Breaking the fall with circuit filters

One reason for the sharp decline in asset prices last week was the absence of circuit breakers on securities in the derivatives segment. There is now a debate as to whether the stock exchanges should impose circuit breakers on these securities as well. This article argues that such a device may be against the free-market forces but helps in moderating margin calls during crashes.

B. Venkatesh

The market crash on January 21, 2008 and the following day saw many investors lose most of what they had earned in the last four years.

Those who had exposure to derivatives and to stocks that were part of the derivatives segment were the worst affected, as such securities do not have circuit breakers.

This has led many to wonder whether the stock exchanges should have circuit breakers on all securities. If there were a circuit breaker on, say, Reliance Natural Resources, the stock would not have fallen from Rs 203 to Rs 145 on a single day.

Circuit breakers work against the free-market forces- traders cannot freely price their behaviour into the asset. But not having one creates problems too.

We believe that circuit breakers moderate distress sale due to margin calls. And that, in turn, moderates the severity of a crash. Circuit breakers on all securities could play a vital role in the market microstructure.

What free market?

A circuit-breaker is a device that halts trading in a stock if the price changes by a pre-determined percentage on a given day. The stock exchanges currently have 2, 5, 10 and 20 per cent circuit breakers on stocks that are not part of the derivatives segment.

Votaries of free-markets think that circuit breakers only cause more panic. Free-market is good if we are disciplined.

But psychologists have showed that we are not wired for discipline. The fact that a market crash occurs almost every year is standing testimony to our lack of discipline.

A tempered external interference is required to smoothen the functioning of any system. This is true of traffic systems as it is of emergency exits.

In a study conducted after a truck-bomb attack in 1993 on the World Trader Center, researchers found that a post installed near the emergency exit helps the evacuees. Why? The post tempers a collision of people at the exit and prevents a pile-up.

The case is no different with the financial markets. We overreact to information. If Infosys reports an unexpected increase in earnings, we enthusiastically bid up the asset price only to realize soon thereafter that we were hasty in doing so.

Likewise, on January 21, 2008 our overreaction pushed most asset prices down 25-40 per cent.

Having circuit breakers on securities in the derivatives segment would have given us time to ruminate and temper our overreaction. It acts like a post at the emergency exit that forces people to gather their buy-sells in an orderly manner.

The portfolios that had minimum losses last week were ironically the ones that were loaded on stocks with 5 and 10 per cent circuits! And most of these stocks are fundamentally weaker than the large caps and mid-caps that took a sound beating.

NSE and Derivatives

The free-market supporters believe that it is not about circuit breakers. Rather, it is all about the stocks that constitute the derivatives segment.

They argue that stocks such as Ispat Industries and Oswal Agro should not be part of the derivatives segment at all. And even if they were to be included, NSE should shed the rule of a contract size based on value.

Instead, having 100 as a uniform contract size would help. This, by itself, could moderate the fall.

As for the other stocks, the free-market supporters argue it is best to let the asset prices witness a free-fall. That way, the downside correction may be over in a short period.

But circuit breakers play a pivotal role that the free-market supporters fail to see. And that is to do with margin calls.

When the near-month futures on Reliance Natural Resources declined from Rs 207 on Friday to Rs 158 on Monday, traders had to pay a mark-to-market margin of Rs 1,40,000 on each futures contract. Such margin has to be always paid in cash.

The margin requirement would have certainly been lower if the underlying and the futures contract had a 10 per cent circuit breaker.

It is important to impose circuit breaker on futures as well as the underlying. Imposing on the underlying and not the futures contract will lead to disconnect in the prices.

Yes, the traders in a fit of panic may push the price down the next day as well. But margin calls may not be exacerbated. After all, the trader will have one more day to arrange for funds. And that is important when a market crashes.

Tempering margin-call requirement is an important factor in market crashes.

Maybe this is good reason for the stock exchanges to impose circuit breakers on all securities- till one finds a better device to moderate human behaviour and the resulting market crash.

(The author is a Chennai-based investment strategist. He can be reached at enhancek@gmail.com)

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