Do circuit breakers help control free fall in markets?

Latha S Chari/Pradiptharathi Panda Latha S Chari/Pradiptarathi Panda | Updated on April 06, 2020 Published on April 03, 2020

On all past occasions, the markets saw good same-day recovery after market-wide circuit breakers. But this pattern was broken on March 23

Efficient, well-functioning stock markets with adequate transparency, liquidity, price efficiency, and resilience to shocks is a pre-requisite for the growth and development of all economies. In the past, events like demonetisation, the Chinese currency devaluation, European Union economic woes and Brexit have resulted in large single-day market crashes and extreme movements in the index of different markets across the globe, including India.

To protect market integrity and prevent systemic risk, regulators have applied mechanisms to constrain trade like market-wide circuit breakers, price limits, and stock-based trading halts. It is felt that these constraining mechanisms will provide time to the market participants to understand the impact of the events, prevent panic, facilitate efficient price discovery, and protect the intermediaries and clearing corporation from facing sudden widespread market defaults. The question of whether such constraining mechanisms are useful and help curb panic-driven volatility has been raised on many occasions.

The index-based market-wide circuit breakers (MWCB) were triggered twice in quick succession in the Indian markets on Friday, March 13, and Monday, March, 23, 2020 — aftera gap of nine years. The key reasons were the coronavirus scare and the global market meltdown. These occasions have given us an opportunity to test the effectiveness of the existing mechanisms once again.

Recovery seen

In Indian stock markets, the MWCB is applied when one of the prime indices i.e, Sensex or Nifty, moves by 10 per cent, 15 per cent, and 20 per cent on either side with respect to the previous closing value. Both equity cash and derivative segments across both the exchanges are brought to a co-ordinated halt. The MWCB on March 13 was triggered by a 10 per cent fall in Nifty-50 a little after the market opened (at 9.20 am). The markets opened at 9,107, ie, 5 per cent (483 points) lower than the previous day’s closing of 9,590. However, the Nifty fell further and triggered the 10 per cent mark resulting in the application of the MWCB and a trading halt of 45 minutes.

On resumption of trade, the Nifty-50 quickly (at 10.05 am) recovered the 10 per cent fall and went past the previous close by 365 points to close much higher during the day at 9,955. The same day recovery in Nifty was 16 per cent from the day’s low, on its closing value.

On March 23, the MWCB was triggered by a 10 per cent fall of the Sensex (at 09.58 am). The Sensex had opened at 27,608.8, ie 2.4 per cent (680 points) lower than the previous trading day closing of 28,288.23. However, both the Sensex and Nifty fell rapidly after opening, and the Sensex hit the 10 per cent lower circuit by falling 2,828 points, thereby triggering the circuit breaker.

On opening, the markets showed some recovery, only to slip back lower. On closing, the Sensex lost 3,934 (13.94 per cent) points and closed at 25,981; the Nifty lost 1,135 points on the same day (13.01 per cent) and closed at 7,610. This is one rare occasion when the market has shown a price continuation trend after the application of MWCB and resumption of trading.

Deviation from pas trends

The recent two occasions have been different from the past occasions in terms of price reversals and volatility. The past occasions when the circuit breaker was applied along with its impact on the market are in the Table. The question of whether the circuit breaker helps in curbing volatility and panic is measured by looking at the percentage of recovery from the day’s low/high when trading is resumed after the halt. On all the five occasions in the past, when the lower circuit triggered the trading halt, the markets have recovered back from the day’s low significantly.

The market recovery pattern on March 13, in fact, has been better than the past five occasions at 16 per cent. This kind of recovery after hitting the lower circuit on MWCB has not happened in the past. While the circuit breaker mechanism has helped curb free fall, the better than expected same-day recovery was maybe because of the short-covering after trading resumed. On subsequent days, the markets continued to fall with the reversal trend not sustaining.

After the lower circuit on March 23, there was no sustained recovery based on the closing date of both indices. Both the Sensex and Nifty fell a further 3 per cent. This was due to the lockdown and global uncertainty, which resulted in the biggest intra-day fall in the history of India. The India VIX index in March 2020 continues to be three times the average monthly VIX. The MWCB at best help the markets to pause and re-evaluate, but may not help curb volatility in the long run

Chari is Professor and Panda is Assistant Professor, NISM. Views are personal

Published on April 03, 2020

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