Why a Circuit Breaker in China Does Not Work

Circuit Breaker Mechanism in China

Circuit breakers are measures that temporarily halt trading in exchange market or individual securities to control volatility. Once the circuit breaker is in place, investors and traders can carefully reassess the situation and decide what they need to do. The mechanism limits credit risks and loss of financial confidence by providing a ‘time out’ amid frenetic trading to settle up and ensure everyone’s solvency. The mechanism is inclusive of the measures approved by the SEC to curb panic at stock exchanges and excessive volatilities (Horowitz, 2020).

The introduction of the mechanism was advocated in the Brandy Committee report that investigated “Black Monday” in 1987. It was later introduced into the world securities exchanges such as Brazil, India, U.S, and Japan. The system was adopted in China a week ago to reduce volatility. The mechanism suspends trade for 15 minutes once the losses reach the five percent index. If the losses hit seven percent, the market is suspended for the entire day. This essay advances the argument why the proposed mechanism does not work in China.

Justification for Circuit Breaker Mechanism

The circuit breaker system has several positive effects on the market system. The first one is that it effectively prevents the misdistribution of profits. The intention of the system is to control rapid changes of the stock prices and evade confusion of the market. Previous studies showed that the circuit breakers significantly reduce the volatility when liquidity of the market is low (Hashimoto & Kobayashi, 2016). On the other hand, the impact of the mechanism on stabilizing the market is less evident under high liquidity, when the circuit breaker mechanism prevents misdistribution of profits and then destabilizes the settlement system, which is induced by increased bankruptcy (Hashimoto & Kobayashi, 2016). The circuit breaker system helps to stabilize the market settlement since the operation of the method significantly lowers the number of bankrupt traders. It also indicates that the system can reduce the volatility of future prices.

A previous study recommends that coordinated circuit breakers should be introduced in the market system so as to halt or limit trading in times of market stress. The measures were to be mandatory across all domestic equity and equity derivative markets. The information of enhanced price and trade is to be made available during the periods when circuit breakers have been triggered. Potential buyers in the real market may not always be sure of the price levels at which their market orders will meet. It occurs in the case where the market makers are confronting an unexpectedly large amount of sell orders. This uncertainty of the prices might lead to deviations. There are two periods that contain uncertainty; information less supply shock in the first period and buyers alive in the second period. The uncertainty affects the demand behavior of value buyers during the second period, and it, in turn, affects the suppliers’ behavior in period one. It means that when a supply shock is large, its transmission to the value buyers causes a microstructure-induced crash. The circuit breaker can reduce the uncertainty of the value buyers by basically making the value buyers aware of the response of traders to large shocks. The tradeoff owing to circuit breakers is between full information pricing and timeliness of execution.

Why the Circuit Breaker Mechanism does not Work in China

In spite of its known success in market stabilization, the circuit breaker mechanism has various limitations that rendered it ineffective in China. One of the major effects of the breakers is causing panic to the traders who intend to close their deals and avoid being locked out from further trading. In China, once a five percent threshold is reached, a 15-minutes halt is initiated. After the halt, traders rush to sell and almost inevitably hit the seven percent threshold. Thus, trading is stopped until the following day. The small margin between the intervals of initiating market closure creates tension among traders (Deng, 2016). The effect is referred to as gravitational pull between the two margins. Moreover, the heavy involvement of China’s individual investors in the market increases the gravitational pull. It results to an increase of the volatility level. In contrast, the SEC initiates halt once the S&P 500 index reaches seven percent. The next interval is 13 percent, and the last one is 20 percent. The difference between them is wide enough not to induce tension and also creates ample space for the volatility to reduce to comfortable levels (Tang, 2016).

The second limitation of the mechanism is that instead of stabilizing the market, it caused a wave of selling. Chinese investors argued that the trigger levels were quite low and close to working effectively. It is argued that the adverse effects of the mechanism outweighed the positive ones (Wangdong, 2016). The intention of the mechanism introduction was to protect investors and calm markets according to regulators. Instead, it had the opposite effect. It led to the panicking of investors who worried that they would not be able to sell shares that they did not want. The mechanism did not convince them of market stability. It led to the suspension of the mechanism in the country only a week after it was introduced.

Another effect of the mechanism was creating liquidity issues. Once the index has suspended trading, liquidity basically dries up. The circuit breaker mechanism aims at calming down the investors. It also leaves time for them to consider and reduce non-rational factors to stabilize the market. However, retail investors account for a bigger portion in the investor structure, and it makes it easy to cause tension and restrict liquidity when the market becomes unstable. It forces the institutional investors to follow the sell-into-corrections of retail investors so as to deal with redemption. Hence, it is expected that the regulator will channel the rule related to seven percent to protect liquidity. However, the CSRC’s intention to suspend the circuit system entirely precedes the industrial expectation, which is predicted to influence the market positively.

Another effect of the circuit mechanism is that while it controls price fluctuations and stabilizes the settlement systems, it reduces the trading volume (Hashimoto & Kobayashi, 2016). Total trading volume falls as the period of interruptions increases. It implies fewer trade opportunities as a result of the mechanism activity. In cases of large price fluctuations, the number of implementations of circuit breaker increases as the ratio of random agents goes down. The reduction of the trading volume in China will definitely have adverse effects on the country’s trade. Reduced trade volume means that investors are scared away from the country, which would be a blow to its economy.

The circuit breaker mechanism has spillover effects depending on the market conditions. The mechanism failed to calm the market in China but instead caused sell-offs, creating a spill-over effect that affected the global market. It happened because China is one of the biggest economies in the world. It has become a key benefactor for the third-world countries, especially in Asia and Africa. The tumbling of the local Chinese market will spill over to the other countries. The faltering in the market led to the market becoming less liquid, which made investors rush to sell their stocks due to fears that the next halt would lock them out. The decision of ceasing the use of mechanism by China relieved its investors, and, as a result, the share price pushed higher. Regional markets, such as Taiwan, followed suit in pushing the price higher (Huang, 2016). It is a demonstration that the Chinese economy has a significant effect on the operations of the regional economies and the entire world economy.

The other limitation of the circuit breaker mechanism is its effects on increasing price variability and consequently exacerbating price movements. Traders will distribute their trades across periods when the circuit breaker mechanism is not operational to reduce the impact of price on their trades. The traders have the choice of timing their sales at their own desired period. Profit maximization is enhanced due to proper timing of higher prices. There is also an even distribution of income over a certain period. However, with the introduction of circuit breakers, the traders’ trading behavior is tampered. The mechanism will force the traders to concentrate on their trade at earlier periods. In their assumption, the price in period two will be halted while that of period one will not. The trader will assume that the price in period one will be outside the circuit breaker. The trader’s behavior in the time when the circuit mechanism is in effect will be influenced by the system rather than price timing. The expected cost of not being able to trade in period two will outweigh the advantages of splitting their trades. As a result, price variability increases and the chances of the period-one price crossing the limits also increases.

Other than disrupting trade activities, Lok (2016) explains that the circuit mechanism could also slow price discovery process. For the system to regulate extreme price movements, it could impede price discovery at times of its introduction in the market. When the mechanism reaches its limits, it leads to the constraining of the natural price adjustment process. Once China stock market indexes fell by more than five percent in a few minutes during the violent market disruption on that day and then rebounded almost entirely after another three minutes, it left market structure gaps exposed. It has led to questioning the integrity of the market and its price discovery functions. Thus, the mechanism should be applied as the last option. The system requires being implemented in a harmonized way throughout exchanges to provide the investors with similar expectations.

Another argument why the circuit mechanism has not worked in China is because the country’s economy is one of the biggest in the entire Asian region. Its economy has experienced a rough start at the beginning of the year. For instance, Shanghai Composite tumbled 168 points equal to five percent while the Shenzen composite plunged 130, which is six percent (Choudhury, 2016). The circuit breaker was designed to trigger a 15 minutes trade halt if the CSI 300 index fell by five percent. Moreover, it would trigger a complete halt if the index moved by seven percent. In either case, the mechanism proved ineffective. The investors remained wary of the country’s ability to handle a financial crisis. The problems existing in Asia’s largest economy are too broad to be handled by the circuit breaker mechanism. The ability of China to influence the trend of the entire Asia’s economy, therefore, indicates that the new mechanism cannot work in this country. Furthermore, the method proved ineffective in China only a few days after its introduction insinuating that the system cannot handle the entire Asian economy.

Conclusion

As discussed above, while the circuit breaker mechanism has proved to be an effective method of controlling major market fluctuations in other economies, it has not been the case with China. The system crumbled in the initial days of its introduction and thus proved ineffective. Inferentially, the timing of the introduction of the system by the market regulators was poor. It was done at a time when the Chinese currency has been decreasing. The investors were in tension even before the introduction of the mechanism. The entire Asian economy has in the past few months experienced a minor crisis. The introduction of the new mechanism triggered tension and thus did not function properly. With the evaluation of the index margins, the gravitational pull effect would be handled. Ample time of familiarizing with the system would help the investors avoid rushing to close their deals, and hence, the mechanism would operate effectively.