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Stock exchanges across the world impose circuit filters to check excessive volatility in the markets. There is a percentage limit set for each stock and indices beyond which the stock or index can’t be traded. This is the maximum fluctuation that is allowed in the price during trading. As taught by investment banking courses in India, if the stock or the index hits the maximum permissible limit in either direction, the exchanges suspend the trading for the remainder of the day.
As an example, the New York Stock Exchange (NYSE) sets three trading curb levels at 7% (L1), 13% (L2), & 20% (L3) of the average closing price of the S&P 500. The exchange takes action depending on the point drop that happens. The L1 and L2 drops result in a suspension of trading for 15 minutes and an L3 results in stoppage of trading for the rest of the day.
The Bombay Stock Exchange (BSE) has imposed additional circuit filters or price limits to over 3700+ stocks. These are weekly, monthly, quarterly and even yearly limits over and above the already existing daily limits. There are daily price bands wherein the exchange does not allow stocks to move beyond 2,5,10 and 20 percent on any given trading day. As per the new rule, which even the school of investment banking teaches, there will be weekly, monthly, quarterly and even yearly circuit limits. The percentage limits will depend on the existing daily limits for the stocks.
This move is intended towards reducing stock manipulation. While the intent is very good, it may prove counterproductive as it will adversely impact liquidity and trading volumes. A large number of stocks are already illiquid and it may only lead to dwindling trading volumes for these stocks. This move seems to be in contradiction to the very purpose for which an exchange exists – to provide a liquid market for listed stocks. Financial markets perform two major economic functions, Liquidity and Price Discovery. Large trading volumes not just help the price discovery but also reduce transaction cost.
What is required is a more robust surveillance mechanism, closely monitoring not just the prices movements but also monitoring the trading positions of trading members, frequenting the stocks in question. The move to impose additional limits will only bring about a change in the trading strategies of the interested trading members who are responsible for the manipulation. The ones to lose will be the investor at large who will have more liquidity issues than before. Having said that as an alternative, the exchange may want to initially experiment with only those stocks with a threshold market capitalisation and review the same on a periodic basis. Given the biggest downside being reduction in trading volumes, the rule may initially be imposed only on stocks with a decent trading volumes (read market capitalisation).
Whether the move will achieve its objective or not, only time will tell but the impact on some of the illiquid stocks may be far more than the ones with better trading volumes. The exchange will surely be monitoring the stocks particularly illiquid ones closely and will take timely corrective action before it’s too late.