New circuit-breaker rules have been tested already, but are they a solution for market volatility?

Written by Paolo Di Fonzo || January 07 2016

When the Shanghai Stock Market first opened after the New Year’s holiday, everything quickly turned for the worst: a fast, large rout emerged, with the CSI300 Index losing 5 percentage points by 1 am. Then it stopped for 15 minutes, as trades were paused. After the break ended, the index kept going down, down in fact 7% on the previous trading day in just two minutes. At this point negotiations stopped again, but this time for the rest of the day.

In both cases what happened was that a certain threshold was reached and the new circuit-breakers were triggered. These circuit breakers were announced in 2015, launched on the fourth of January and in fact tested on the same day. Circuit-breakers, also known as trading curbs, are a particular form of automtic triggers designed to stop trades on the whole market when indexes are losing too much and there is significant risk for sudden crashes.

After the summer of 2015’s market crash, regulators introduced China's circuit-breakers a threshold at 5% for individual stocks and 7% for the broader market. The idea was to reduce market volatility and sudden market routs that were so devastating during July and August. The question is: does this work? And if not, is the problem the circuit-breaker itself or should the thresholds be changed?

In the United States, circuit-breakers were introduced after Black Monday in the 80s and have a three-layered structure: at the first two thresholds (negative variations of 7% and 13% on the S&P500 index) an automatic 15 minutes break will be forced on the markets, while if a loss of 20% occurs transactions would be suspended for the rest of the day.

As it can be seen these values are much larger than their Chinese counterparts and, in nearly 30 years of life, the whole-day suspension was triggered only once in 1997.

On that occasion, the mechanism was criticised as the reason why the index dropped so fast after the first 15 minutes pause: the idea is that when uncertainty is high (i.e. when there is peak need for a stabilising effect) the activation of the circuit-breaker creates expectation that as soon as the 15 minutes go by the market will keep going down until they reach the second layer, everybody is anticipating that and so starts selling right when the transactions are allowed again, effectively creating another rout and pulling the index down to the lower band.

This self-fulfilling prophecy is especially true when the values are very close, like in China, which is why many are suggesting that the CSRC should quickly reconsider these values and rumours are that the regulator is actually thinking about a change.

There is also an argument to be made that is against the introduction of circuit-breakers in China at all: in volatile markets there could be of course huge swings but that goes in both directions. Suspending trades for a whole day however prevents late rebounds, leaving instead the variation on the wrong side of 0.

While this kind of reasoning can make sense, it is also true that it would represent a significant bet on the ability of Chinese markets to rebound during these dire times, whereas circuit-breakers offer a safe spot in which authorities can operate to counter the effects of bad days, something that is surely appreciated by people in Beijing.

The prediction here is that bands will be adjusted in both value and relation with the time of the day, as how they are now they act as a non-stabilising factor. However it has to be remembered that circuit-breakers are not the cause behind volatility, but instead they are just an aggravating element at the moment.

It will be a difficult task for the regulator to find a middle ground that both assures a grip on losses and projects a positive impression on investors, so that they do not perceive that after the first pause the whole day stoppage is inevitable. Given these problems it could make sense in a country like the US to just avoid circuit-breakers at all, but in China the government is actively participating, really more than they should, and without these breakers, it would lose an important tool to gain time for interventions.