Circuit breakers are a means of controlling excessive price volatility in stock markets. A simple example of a circuit breaker is that if the market moves beyond a certain threshold, then further trading is suspended. To answer the question “are circuit breakers a good idea?” we shall be looking at the arguments given for and against circuit breakers and discuss their different forms, particularly the one being used at the Karachi Stock Exchange (KSE).

There are three arguments that favour use of circuit breakers:

I. They offer protection to the clearing-house from systemic risk. Systemic risk refers to the likelihood that the failure of one participant to meet its settlement obligations will cause other participants to be unable to meet theirs. This risk is present in the system because of the time lag between transaction and settlement, which is three days in a T+3 settlement cycle.

If prices fluctuate widely in a short while, some investors are likely to incur substantial losses. These investors might not have liquid assets to pay the margin deposits and find it difficult to get credit. Large scale defaults may cause settlement problems for the clearing house, and thereby for everyone.

II. They protect investor confidence from getting shaken by wide price fluctuations. Even if the clearing house is able to manage settlement risk arising due to wide fluctuations, investors may shy away fearing further sudden and large capital losses.

III. They provide time-outs to markets when they get overheated. There are days when stock market crashed without any convincing reason. Investors might have over-reacted to some news given lack of time to perform necessary analysis. Else, they might have acted as a herd. The drop in Dow Jones Index 508 points or 20.6 per cent on Oct 19, 1987 - popularly known as Black Monday - is an example of such a crash.

Circuit breakers are criticized on the following grounds:

i. They do not let the bargain hunters save the day. If the market panics and falls, some investors shall come to buy the ‘undervalued’shares. Such buying would restore the market equilibrium, which cannot happen due to circuit breakers.

ii. By interfering with the free forces of supply and demand, they create problems in price discovery. If trading is halted in a stock, then its fair value becomes uncertain for all investors.

iii. The idea behind circuit breakers is to soothe public opinion, which does not look favourably at the acrobatics of stock prices even when they are justified.

Design: Circuit breakers can be designed in different ways. They maybe based on market index or on individual shares; there may be a single circuit breaker or a series; they can suspend trading or impose price floors or ceilings; they can work on either a market fall or a rise or both; and their thresholds may stay the same or change if they were activated on the previous day. We think that the following factors are key in determining what sort of circuit breaker to use:

a) Markets that are wide and deep (many securities, many investors, lots of investment/trading) should use index based circuit breakers. Such markets are not subject to the vulnerability of any particular entity because no matter how large, any share, investor, or broker is, it shall be very small compared to the total market.

b) Wide and deep markets should use trading halts rather than price jams. You can trust such a market to regulate itself by investor rationality rather than regulations. What you need to do is provide the market with a break when it does not have time to rationally evaluate a surprise.

c) In index-based circuit breakers, it’s better to have a series of circuit breaker thresholds because a single threshold may be too narrow or too wide.

d) Markets that have better risk management can have relatively lenient circuit breakers.Please note that circuit breakers are only one of several inter-linked risk management measures such as margin deposits, capital adequacy thresholds, clearing house protection fund etc.

e) Market in which there is little short selling and blank selling is effectively prohibited may have wider downward circuit breakers because they are not vulnerable to bear raids. Similarly, such markets can have wider or no upward circuit breakers because if the market rises and those carrying short positions incur losses, they shall have the securities to deliver.

f) Circuit breakers that use a dynamic percentage threshold are better than those with a static absolute threshold as the former change with respect to market situation.

g) Circuit breakers in Stock-Futures should be the same as those in the ready market as Futures derive their values from underlying stocks or indexes.

Most of the stock exchanges, London Stock Exchange, Bombay Stock Exchange, Kuala Lumpur Stock Exchange, etc follow variants of NYSE model. The possible reasons behind the dominance of NYSE model are cross listing of shares and a tendency to follow the leader.

Assessing circuit breakers at the KSE: The KSE has a narrow base in scrips. Almost 99 per cent of traded value is confined to 25 shares. In other words, 95 per cent of receivables and payables are also concentrated in these shares. It is therefore important to manage risk in individual securities. It also makes sense to have wider circuit breakers on the upward side for all scrips, as the risk involved in a long position are less than those in a short position. Moreover, lack of upward circuit breakers can cause large technical bubbles and over-leveraging by speculators.

We think that the circuit breakers at the KSE can be improved in the light of the following:

* Circuit breakers for the illiquid scrips should be wider because these are subject to larger fluctuations. Narrow circuit breakers make them even more illiquid without any help in risk management or investor confidence.

* Circuit breakers should be dynamic. It means that they should adjust themselves with the changing market condition. As the price and turnover of a scrip increase, its circuit breakers should become narrower and vice verca.

* There should preferably be trading halts for individual securities on impending corporate announcements that are likely to significantly impact the stock price. This would provide the investors, particularly, clients of brokers who do not have real-time access to such announcements, with the necessary time to rationally react to the information.